Trying to time the market is expensive, and almost never works in the long run. Market timing is a recipe for high transaction fee, higher taxes, and unwarranted complexity, with no empirical evidence of higher returns.
Markets are inherently volatile, and with volatility comes the impulse to react.
Investors do not know definitively whether the markets have peaked or bottomed out, except in retrospect.
Changing portfolio allocation in response to market movements incurs transaction fees, and may add to your tax liabilities.
A prudent alternative is to understand how much extra you may need to save towards your financial goals.
Whether you are a first-time investor with no clue where to begin or someone with an existing investment portfolio, you are likely aware of the dictum ‘buy low and sell high. The idea is intuitively appealing - there have been market lows when investment securities (say, equity shares) could be had for a bargain, and highs when it was best to sell. But could these highs and lows be predicted accurately at the time?
The fallacy of market timing
Turns out, very few of us are any good at timing the market. As per data published by the Association of Mutual Funds in India (AMFI), increased inflows into Indian equity mutual fund schemes closely track share market rallies, and vice versa. This suggests that investors tend to flock to equity mutual funds when the equity markets are priced at a premium, and they rush to sell when the markets are priced at a discount; effectively, buying high and selling low.
Data suggests that most professional investors are no better than the rest of us at timing market highs and lows. The reason for this should not be too difficult to understand. It is hard enough to sell when the market sentiment is sanguine and there is optimism all around, and harder still to buy when the markets have tumbled and everyone else is headed in the opposite direction.
Perhaps the single most important reason why predicting the market remains so fiendishly difficult is that it is heavily influenced by the vagaries of human psychology. Nothing illustrates this better than the research conducted by Robert Shiller, a Nobel Prize winning economist, on the global market crash of October 19, 1987, also known as the Black Monday. Summarising his conclusions for The New York Times, Professor Shiller wrote, “. . . the 1987 stock market fall was a panic caused by fear and based on rumors, not on real danger. In 1987, a powerful feedback loop from human to human — not computer to computer — set the market spinning.”
Opportunity cost of not being invested
A serious risk of trying to time the market is the opportunity cost of being out of the market longer than necessary. Once the decision to sell in anticipation of market decline has been made, it remains extraordinary difficult to correctly time your entry back into the market. And it takes only a few days not being invested to severely impact your returns for the entire year.
As Ridham Desai, the Managing Director of Morgan Stanley India, points out, “Since March 1995, the market in India has traded for 5,460 days. Over this period, the index has gained 824 percent. Over these 22 years, 100 trading days accounted for about 60 percent of this return. Imagine if someone through some analysis decided to stay out of the market for these 100 days; that person would have missed 1.5 percent of the action in time terms and 60 percent in return terms.”
In fact, many of the largest single-day gains in stock markets tend to occur within a few days of the large single-day declines, making it nearly impossible to consistently get your entry and exit timing right. Consider the following examples:
On January 25, 2008, the Sensex went up by a massive 1139.92 points, just four days after losing 1408.35 points in a single day. Something similar happened again on October 31, 2008 when the Sensex rose 743.55 points, just 7 days after a 1070.63 point single-day decline. And so on.
Fees and taxes
The success or failure of your market timing decision notwithstanding, frequent churning of your investment portfolio has significant associated costs.
First and foremost, there are tax consequences. When you sell equity shares or equity mutual fund units within a year of investing, you are liable to pay a 15% short-term capital gains tax (plus applicable surcharge and cess). In contrast, upto 1 lakh in long-term capital gains on equity investments during the financial year are tax-exempt; excess gains are taxed at 10% (plus applicable surcharge and cess). Similarly, when you sell debt mutual fund units within 3 years of investing, you do not get the benefit of indexation while calculating your tax liability.
Moreover, when you sell your equity mutual fund units within a year of investing, most mutual funds charge a 1% exit load on the withdrawal. Collectively these costs tend to significantly erode your investment returns.
Market timing by default
Even if you do not actively try to time the market, you effectively end up doing just that by investing or withdrawing lump sum.
At Clarified we are big proponents of investing in mutual funds via Systematic Investment Plans (SIP), and staying invested for the long term. Investing a fixed amount every month or quarter via SIP can help you around this problem through ‘rupee cost averaging’ - by investing on a fixed schedule you buy fewer units when the market is expensive, and more units when it has corrected.
Similarly, when withdrawing funds for your planned goals, we recommend that you spread the redemption over a few months using Systematic Withdrawal Plans (SWP) where possible.
What you should do instead
When planning your investments, the ideal starting point is to recognise that we save and invest to be financially prepared for our life goals - retirement, buying a home, child’s education, etc. - and not to beat benchmark returns. So, if long-term wealth creation is your objective, understanding how much extra you could save goes much further than trying to time the market.
It also helps to acknowledge that investment returns do not accrue like clockwork. Markets are inherently volatile, and as an investor you are sure to see both good times and bad. However, with a saving and investing horizon that hopefully spans a few decades, the factor crucial to wealth creation is not ‘timing the market’ but ‘time in the market’.
Published on: September 5, 2018