Archive for June, 2007

Does Market Timing Work?

June 21, 2007

24 comments

In her book Juggling Dynamite, money manager Danielle Park, points out that an investor who avoided the 10 worst days of the market would have posted returns of 5.9% and 59% in 2002 and 2003 compared to -24.2% and 26.4% for a buy-and-hold investor in the S&P 500. She says:

In fact, history shows that investors who avoid the big market downturns need only capture 30% of the next upmarket cycle in order to fare just as well as perpetually invested and therefore more risk-exposed buy-and-hold investors.
Numbers such as these make it very difficult to argue that there would not be lasting benefits were investors able to step out of markets and avoid the bulk of the ugly price corrections and the resulting losses.

There are two questions that average investors need to ask of any investment philosophy that promises more reward (for the same level of risk) or less risk (for the same level of reward) when compared to a stock index:

  1. Has it worked in the past? Is the after-tax return (adjusted for risk) better than simply buying and holding the index? Is there any reason to believe it will continue to work in the future?
  2. Can the average investor successfully follow the investment strategy?

Unfortunately, market timing fails both tests. I don’t know the track record of Ms. Park’s strategy for market timing compared to the S&P 500 (let alone a diversified portfolio) but we do have some evidence about how successful market timers are as a group. According to Mark Hulbert, who tracks market-timing newsletters, roughly 80% of newsletters under perform the market indexes. John Bogle, as you would expect, has a devastating opinion on market timing:

In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely, not only not to add value to your investment program, but to be counterproductive.

Even if you believe that market timing works, you have to decide if you’ll be good at it. By definition, market-beating strategies are hard to practise because if everyone can do it, they will have acted on it already and ironically, it won’t work anymore.

The choice for average investors is clear: buy-and-hold a diversified portfolio of low-cost funds and rebalance regularly. Let’s say that an unlucky investor with a 75% exposure to equities, invested a lump-sum just as the market was peaking in 2000. At the end of 2006, he would have earned an annualized return of 3.6% during one of the worst bear markets in history. The good news is that unlike the unlucky investor, we save and invest periodically, in bull and bear markets and our returns are likely to average about 6% even in a low-return environment.

Tax Freedom Day

June 19, 2007

27 comments

The Fraser Institute estimates that tax freedom day falls on June 20th this year. The institute defines tax freedom day as:

the day in the year the average Canadian family has earned enough money to pay the taxes imposed on it by the three levels of government: federal, provincial and local.

It is easy to accuse the institute of right-wing bias but the truth remains that we are highly taxed. Worse, as the report points out, a number of taxes (such as the employer’s share of CPP contributions and EI premiums) are effectively hidden but ultimately borne by us.

The critics of the report point out that the institute overstates the income of an average family. For instance, Statistics Canada’s data show that a median two person Canadian family earned an income of $57,700 (in 2005). The Fraser Institute’s estimate for cash income for an “average family” is significantly higher at $83,775. Still, the report is a timely reminder of how much tax we pay.

Should You Leverage?

June 18, 2007

16 comments

[I was going to list all the reasons when you shouldn’t leverage and conclude with a maybe, but Thicken My Wallet beat me to it with a great post on this very topic. I have slightly reworked this post to avoid being redundant.]

Many of my fellow bloggers seem to think that leverage should be a part of every financial plan. While it may be a suitable choice for their own financial situation, I think it is unwise to suggest that everyone should get an investment loan.

It is easy to understand the logic behind leverage: you borrow money from your friendly banker at say 6% and invest it in equities and earn a greater return. As an added bonus, you also get to arbitrage the difference between tax treatment of interest payments (100% deductible against income) and capital gains (or dividends). Voila! You are making money on money you don’t have! What a great deal!

The problem with this logic is that for leverage to make a significant difference to your bottom line, you’ll have to borrow huge amounts of money. Let’s say that, on average, you expect to borrow at 3% and hope to earn 7% in the equity market. Your estimated average spread is 4%. To earn an extra $1,000 per year, you need to borrow and invest $25,000. Let’s say you heard the siren song of leveraging, borrowed and invested $25,000. The markets tumble 20% over the next year. Would you have the fortitude to stick with the plan, now that you are $8,600 in the hole? Only if you have lived through a bear market, you can answer that question..

I’ll admit that leverage would have worked splendidly in the past few years. The total returns from the TSX Composite for the past four years has been 26.7%, 14.5%, 24.1% and 17.3%. By borrowing at less than 6% (most of the time it was more like 4%), you would have made a nice profit in leveraging to invest. Now, ask yourself this question: If leveraging is such a no-brainer, why wasn’t it popular in 2002? Chasing recent returns is the surest route to investment ruin.

On a personal note, I have occasionally leveraged to invest in equities in the past. But I use leverage strictly as a liquidity tool when I don’t have enough cash to invest and I think there is an irresistible bargain in the market. I also try and pay down the investment loan within the next year and I have a strict rule of never leveraging more than 10% of the portfolio value. Even if everything goes wrong (investments tank, interest rates spike and our incomes plummet), I want to be assured that we would survive to fight another day with a mere financial flesh wound.