Whenever the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before it happens.
It sounds easy when you’re looking in the rearview mirror. But timing when you’re in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long-term vision and goal. Short-term emotional thinking can cloud long-term investment decisions.
The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested.
Mr. James has $1 million invested in a non-registered account and is currently earning $35,000, or 3.5 per cent, in annual income (primarily dividend income and minimal interest income). In addition to this income, Mr. James’s investments have averaged 6.5 per cent annually in capital gains over time.
The total annual average rate of return is the sum of both of these parts — the income and capital gains. The total average annual rate of return over the last five years has been approximately 10.0 per cent annually.
Mr. James decided that he wanted to be a market timer. By market timer, we mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets.
If Mr. James sells off his investments and converts his portfolio to 100 per cent cash, then his gross income will drop to $40,000 per year, assuming that savings accounts are earning 4.0 per cent.
The downside to savings accounts is that interest income is fully taxable each year in a non-registered account. Mr. James currently has the majority of his investments earning tax efficient dividend income with tax deferred growth.
As a result of the difference in taxation between interest income and dividend income, the impact on income would be far greater. For purposes of this article, we have assumed that both interest income and dividend income are equal. In addition to the differential in the income lost, Mr. James would not have potential for capital gains while out of the market.
Mr. James should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments.
If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold. If Mr. James has a stock that has declined in value and he realizes a loss, then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.
From an income standpoint, Mr. James will immediately see his dividend/investment income drop. He will also possibly be losing capital growth on his portfolio.
The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. James. It is the change in the capital side or growth that is the tough part to compute to determine whether Mr. James made the right decision to liquidate.
If the stock market increases, then Mr. James has clearly made a mistake. He will have lost the differential in the income and the capital growth. If the markets remain flat, then Mr. James still has made a mistake as his income will drop, and he must immediately pay tax on any realized gains.
If the stock market goes down, it’s not necessarily a given that Mr. James will benefit from having liquidated his account. If Mr. James makes a correct prediction that the stock market will decline, then for him to benefit he must also make another correct timing decision to buy back into the market at lower levels to potentially be better off. If the markets decline and Mr. James does not have the insight to buy back in (before it rises back to the level that Mr. James originally sold at) then he would still be worse off.
In essence, Mr. James must make two correct timing decisions: (1) selling before the markets decline, and (2) buying back in before they rise.
Mr. James should also factor in the timing in which he feels his predictions for the market will unfold. Making two correct short-term timing decisions against a stock market that has a long-term upward bias is not as easy as it may seem. The markets can rebound incredibly fast.
From a psychological standpoint, most people that sell for market timing fears would also have the tendency to fear that the markets will decline even further, rather than viewing this as a buying opportunity and the time to get back into the markets. Sticking to a long-term disciplined strategy helps deal with the short-term swings of the market.
Missing the best days is detrimental for investment performance
Staying invested in the market is important because the best and worst days in the stock market tend to cluster together, making market timing difficult. The impact that missing the best days has on investment performance is profound.
To illustrate this point, the following scenarios were compiled by Scotia Asset Management using data from the Bloomberg S&P 500 Composite Total Return Index (the “Index”) between Jan. 2, 2015, and Sept. 30, 2024. It assumes that, at the beginning of January 2014, four investors (A, B, C, and D) each had $1 million to invest.
• Investor A missed the 30 best days. The accumulated returns would be $87,200, and value of Investor A’s account on Sept. 30, 2024, would be approximately $1,087,200.
• Investor B missed the 20 best days. The returns would be $412,100, and value of Investor B’s account on Sept. 30, 2024, would be approximately $1,412,100.
• Investor C missed the 10 best days. The returns would be $946,400, and value of Investor C’s account on Sept. 30, 2024, would be approximately $1,946,400.
• Investor D decided to stay invested the entire period. The accumulated returns would be $2,356,600 and value of Investor D’s account on Sept. 30, 2024 would be approximately $3,356,600.
Another related point to why you should stay invested in the market — even if you believe a market pullback is near — is because intra-year market drawdowns are very common and considered normal in the grand scope of the market cycle. They do not necessarily mean calendar year returns will be negative.
In fact, intra-year drawdowns of over ten per cent have happened in twenty of the last thirty-five years for the S&P500. During that same time period, the S&P500 has an average return of 11 per cent per year.
High quality bias can lead to better outcomes
A more practical solution to protecting a portfolio against inevitable (albeit temporary) market declines would be to have a bias toward high quality holdings. This approach has several important benefits and is much simpler than trying something so difficult as predicting market tops and bottoms.
Investing in the stock of higher quality companies tends to offer lower volatility, lower portfolio turnover, capital preservation, and attractive returns commensurate to the risk taken. A high-quality bias defeats the need to time the market, and instead allows a Portfolio Manager to use market volatility as an opportunity to be selective when buying long-term investment holdings.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138, email [email protected], or visit greenardgroup.com.
