Over the past several years, much has been written about how the next U.S. recession and market correction is near. I have read multiple articles suggesting to sell out of equities and move into cash. Now in a previous post about index investing, I mentioned how I would not attempt to time the market. Instead, I would just invest as funds became available regardless of how the market is performing.
In this post, I do not analyse the many reasons why a recession may or may not be imminent. Instead, I am going to assume that I listen to the doomsayers and move into cash. I then try to gauge how precise my timing would need to be to effectively time the market.
To do this, I am going to simulate three hypothetical investors with different investing strategies. All three invest in the S&P500 index for the period between 1983 to the present (2018). This period takes us through the early 1990s recession, early 2000s recession, and the Great recession of 2007-2009.
The simulation will not consider brokerage expenses, taxes, or dividends.
Our Three Investors
Oblivious Oshani
Oblivious Oshani is completely unaware of what is going on in the world. She utilises dollar cost averaging [1] and invests $1000 every month into the S&P500 regardless of how the market is performing. In fact, her $1000 monthly investment is an automated payment that she forgot about a long time ago.
Amazing Arleena
Amazing Arleena comes from deep within the remote highlands of an uncharted pacific island. Her mastery of sorcery has given her the incredible ability to predict future events.
Arleena invests $1000 every month until the market peaks before a correction. She then sells out of the index at its peak and holds cash whilst still collecting $1000 every month. When the market bottoms out, Arleena then buys back into the index at a bargain price and continues as normal.
Cynical Cindy
Cynical Cindy works extremely hard for her cash and is afraid of it vanishing into thin air. At the same time however, she wishes to expand her wealth. She wishes to work less and spend more time reading books, hibernating…and-maybe-get-around-to-booking-that-scuba-lesson-her-friends-bought-for-her-birthday-a-century-ago. [2]
Like Oblivious Oshani and Amazing Arleena, Cynical Cindy invests $1000 every month into the S&P500. She is however afraid of an ever-impeding market crash, especially after reading articles from all the doomsayers. Cynical Cindy therefore sells out when she believes a market correction is near (before the actual peak of the market), waits for the market to crash, and buys back in after the market has recovered.
We will consider several versions of Cynical Cindy as follows:
- Cynical Cindy v1 sells out of the index 1 year before the market peaks
- Cynical Cindy v1.5 sells out 1.5 years before the market peaks
- Cynical Cindy v2 sells out 2 years before the market peaks
- Cynical Cindy v3 sells out 3 years before the market peaks
All versions of Cynical Cindy buy back into the S&P500 one year after it has bottomed out. I must stress that Cynical Cindy is speculating and does not really know when the market will truly peak.
Simulation Results
Amazing Arleena lives up to her name and sails off on her new yacht into retirement. Although with such an amazing ability to see the future, she could have just picked multiple winning lottery tickets and retired much earlier – magical powers seemingly are not correlated with intelligence.
Cynical Cindy v1 and v1.5 beat Oblivious Oshani whilst Cynical Cindy v2 and v3 underperformed.
The simulation of Cynical Cindy shows that to benefit from market timing, one would have to luckily predict a market correction, at most, ~1.5 years before it started. This is an incredible degree of accuracy that many professional analysts and economists have failed to achieve.
Note that the strategies of Amazing Arleena and Cynical Cindy would generate capital gains tax events each time they sold out of the index. If I were to consider taxes, it is possible that Cynical Cindy v1.5 would underperform Oblivious Oshani.
Could I be Amazing Arleena?
With the benefit of hindsight, it is simple for me to pick the market highs and lows in the respective recessions. But in reality, it is incredibly difficult to predict the start and end of a market correction. The Great recession for example was off the radar for many highly respected economists worldwide. So what chance do I have?
As an Average Joe, I lack the knowledge, rationality, and access to data that professional analysts and economists possess. And even if I did, I am still relying on luck in calling the next market crash. Aswath Damodaran, a prominent Professor of Finance at the NYU Stern School of Business, has stated that he has never been able to predict a market correction accurately enough to reallocate his portfolio. He ignores market timing altogether. If the ‘dean of valuation’ cannot time the market, then again, what chance do I have?
Takeaway
If I keep telling myself that the next crash is coming, I eventually will be correct. But to benefit from market timing, I would need to be unrealistically accurate and very lucky. I therefore believe it is best for me to remove market timing from my investing equation. For me, market timing is an exercise in futility.
Note
[1] Oblivious Oshani used dollar cost averaging. I must stress that I do not believe that dollar cost averaging is a good investing strategy. In fact, it is sub-optimal as compared to lump-sum investing. Provided I have a long investing timeframe, lump-sum investing is more likely to outperform dollar cost averaging due to markets rising over the long term.
[2] Any likeness to real people is purely coincidental. All characters are fictional.
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