It’s tougher than usual these days to filter out the noise and stay grounded in what truly drives long-term value. During this time of heightened media discussions and dramatic language, we wanted to revisit our philosophy around the idea of market-timing investment strategies, such as “buying the dip”. In short, we believe that market timing tends to harm rather than help if it leads to cash on the sidelines rather than productively invested and generating wealth for you.
The Mirage of Valuation Metrics
One of the most used metrics to evaluate future investment returns is the Shiller CAPE ratio, short for Cyclically Adjusted Price-to-Earnings ratio, which can be applied to broad equity indices to assess whether the market is over or undervalued. A high CAPE ratio may suggest that the market is overvalued and could lead to lower expected future returns, while a lower CAPE ratio may suggest an undervalued market and higher expected future returns.
The primary issue with this strategy is that it is impossible for an investor to know what future valuations will be. Stocks may appear expensive when compared to historical returns, but in the context of unknown future returns, they could ultimately prove to be a bargain. In essence, the definition of what a high or low valuation is constantly changing.
A paper from AQR Capital Management, called “Market Timing: Sin a Little,” attempted to apply a market-timing strategy using stock valuations of the U.S. equities market from 1900-2015. Overall, the strategy did outperform a buy-and-hold method, but all the gains came from before 1957, and the market-timing strategy underperformed from 1958-2015. This is explained in the paper by the Shiller CAPE ratio generally drifting upwards in the second half of the data, leaving the market-timing strategy underinvested in equities for longer periods. While this does not disprove the fact that a market-timing strategy may work in the future, it highlights that valuations can drift higher or lower for sustained periods of time. One quote from the article below:
“One stark illustration of the challenges contrarian investors face is that in the 1990s our timing strategy gets a strong ’overvalued’ signal (underweights by at least 25%) not in 1999 or even 1996, but in 1991: a painful case of ’early equals wrong.’”
To remind you, the market in 1991-1999 went through an extraordinary period of growth, due mostly to companies involved in the burgeoning internet industry. To put it lightly, missing out on this window would’ve had quite the dampening effect on portfolio returns.
The problem with “buying the dip” is it assumes that there is excess capital to deploy once this dip occurs, creating an opportunity cost of leaving this capital uninvested. On average, a market-timing strategy will hold cash for longer periods, creating a cash drag on the portfolio. In times of high interest rates, this drag can be partially offset up having the cash invested in a high-yield savings account, but this will still lead to underperformance.
Behavioural Challenges
The issues with this strategy do not end there. From a behavioural perspective, the inclination to act hastily as the market rises can result in making purchases at an inopportune moment. Watching a previously held investment continue to climb in value after you sell would test even the most seasoned investor, especially as higher prices are usually accompanied by more media coverage and fanfare.
If you do intend to play your hand in timing the market, purchases during a market downturn should be conducted systematically1. This approach is necessary because dominant narratives often emerge to explain the decline, which may lead you to anticipate further market losses before the market bottom is reached. For instance, during the 2008 financial crisis, many market analysts forecasted additional losses even when the market had bottomed out in April 2009. During the COVID-19 pandemic, many people were more concerned for their health and the health of loved ones, which made taking additional risk in their portfolio more difficult.
Getting You Invested
Due to the overall underperformance of market timing strategies, it appears that investors may benefit from implementing their optimal investment policy as soon as it is established, rather than delaying for a potential market decline. This can be a scary proposition when investing a lump sum of money, and dollar-cost averaging (investing the lump sum over a period of time) may help you feel better.
There’s an investing spectrum; what the math tells us on one end and how we feel about it on the other. If a month from now your lump sum investment has declined by 20 per cent, would you be able to continue to hold those investments? The most important part is staying invested through volatility, and the strategy that allows you to do this is likely the best path for you.
1 Systematic buys in portfolio management can involve purchasing assets when the market declines by a predetermined amount. This strategy requires setting specific thresholds for market downturns, such as a 10% drop in a broad index. When this threshold is met, a fixed amount of capital is deployed to buy assets. By adhering to these predefined rules, investors can avoid the emotional pitfalls of market timing and benefit from purchasing at lower prices during downturns.
Author: Cameron Henderson
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