Key Points

With this limited movement in the stock markets since the past few months, some investors may be tempted to sit on the sidelines, waiting for the next upward movement  before investing in the stock market.

Is the practice of trying to time the market really the best option? Let us evaluate it!

Market timing study

We consider the historical data for the BSE SENSEX to capture the numerous economic cycles between 1980 and 2009. The purpose is to monitor the stock market outperformance of an investor who has managed to avoid either daily or monthly declines in the market.

Table 1 shows the returns obtained by missing the best and worst ten days, as well as the best and the worst ten months for the entire period (end of December 1979 to end of October 2009).

Table 1: Value of Rs. 1 invested in the SENSEX since 1980 with different scenarios   End of October 2009 Annualised Return SENSEX Rs. 134.53 18.4% avoiding all negative months Rs. 15,54,338.71 63.5% avoiding all negative days Rs. 13,322,431,291,963,800,000 356.5% Source: Bloomberg, iFAST Compilations The SENSEX during this period has given an annualised 20.09% returns over the twenty nine year period. Thus, a rupee invested in the SENSEX back in December 1979 would be worth Rs. 134.53 at the end of October 2009.  Taking the study further, we calculated the hypothetical returns if an investor managed to avoid all negative months while investing during this entire twenty nine year period (158 negative months out of the 368 months in the period under study). Such an investor would have grown a single rupee into more than Rs. 15.54 lakhs in twenty nine years. How about an investor who has managed to avoid all the days when the markets have ended in red while invested during this twenty nine year period? The net worth of such an investor would have stood at over Rs. 13 quintillion, or a billion multiplied by a billion, an incredibly large figure (a quintillion is 1018). To put this figure in perspective, the total estimated global economic output was “just” US$60.6 trillion in 2008, and 13 quintillion is almost 2.66 lakh times bigger than the $60.6 trillion.

Chart 1:Outliers can make a huge difference!

Setting more realistic expectations

The results we have derived so far suggest that the investors who can successfully time the market (either by month or by each day) may become a millionaire, or even the richest person in the universe. Obviously, the catch here is that it is practically impossible to time the market on a monthly basis with perfect accuracy over such a long period of time. Needless to say, timing the market with perfect precision on a daily basis over twenty nine years is perhaps an art best reserved for the almighty.

Table 2 shows the same study with more realistic scenarios. Four scenarios were tested, which we believe are plausible outcomes for an individual investor.

Avoiding the “mines” or “potholes” obviously increased returns

Avoiding the ten worst months has increased the annualised returns from 18.4% to 26%, while avoiding the ten worst days increased the annualised returns to 22.4%. This is all well and good for an investor, but it certainly calls for the question: how does an investor manage to avoid these “potholes” in their investment journey?

But missing the best months or days severely impacted performance

Being unable to forecast the future, we believe that our study of missing out on the top ten months or top ten days may have more bearing on determining the investment approach. In the entire 368 months of study, it is surprising to note that missing out on the best ten of those months nearly halved the actual annualised return of the SENSEX. On an absolute return basis, the 13,453% return of the SENSEX was cut to just 1,341% as a result, a very paltry return for almost twenty nine years of investment.

Missing out on the best ten days of market performance in the entire eighty-two year period was less detrimental, but cut the annualised return to 14.2% versus the SENSEX’s 18.4%. On a total return basis, this has translated to a 4,757% return.

Markets are “boring” a large part of the time

As shown in Chart 1, the monthly returns of the SENSEX appear to be normally distributed, with 68% of the monthly returns in the range of -5% to 5%. These are the periods where markets are considered “boring” and often trade in a range bound fashion. However, we believe that the investors should be more excited about the positive occurrences (those on the right side of Chart 1), and should ensure that their portfolios benefit when such hefty gains occur.

Unless one is extremely lucky, the only way to ensure exposure to these positive periods of performance (just 11.5% of the months under study had a positive return of over 10%) is to remain invested in the stock market and avoid timing the market.

Staying invested is the better option

From the results, it appears that while getting market timing calls right (avoiding worst performing days or months), one can generate significantly better performance than the market return. On the other hand, missing out on the best days or months will hurt returns substantially.

Since no one can correctly forecast the direction of the market with precise accuracy, avoiding the worst periods of performance is not easy, and is sometimes an impossible task. Rather than trying to avoid the large negative-return outliers (shown on the left side of Chart 1), a task fraught with uncertainty, investors can choose to “accept” all the huge positive-return occurrences (on the right portion of Chart 1), a certainty if one stays invested in the market.