It is tempting to try to time the stock market. Some investors believe it is possible to enter the market before an upturn and disinvest before a downturn, thereby crystallising large gains. More often than not they are likely to be unsuccessful in their attempts.

If one considers the global market volatility that we are currently experiencing, many investors are now being swayed by their emotions to try to time the markets. There are many ways in which investors attempt to do this. In some cases the decision is as simple as moving into cash for a while until the volatility subsides while others may wish to actively time the markets by moving in and out as necessary. We consider the effectiveness of both these approaches in our research.

First, we consider the effect of moving into cash. Illustration A (click on one of the grey arrows underneath the picture to move between illustrations) shows how your funds would have grown if you had invested R100 in the equity market in January 1980.

The green line assumes that the investor pursues a 'buy and hold' strategy over the period, which means that you do not disinvest regardless of how much the market is falling. The gold lines show how your funds would grow after disinvesting from the market at various times after a 20 percent drop (since 1925, there have been 12 instances where the market has fallen by more than 20 percent) and then moving completely into cash (cash is taxed at a marginal rate of 30 percent, while Capital Gains Tax and costs are ignored).

Investors who sell out are worse off

It is worthwhile to note that if the investor sells out of the market she or he would often be worse off than if he had stayed invested. Although markets may fall even further, and though it may take time for the equity market to beat the returns achieved from being in cash, it can be seen from this graph that the market does eventually provide returns which are superior. When the investor buys into the market again at some point in the future, she or he will probably have to pay higher prices.

The red arrow highlights the effect of the current market downturn on fund values. Of course we don’t know when the market will turn around or if it will fall even more from its current levels, but we can say that long term investors should not be fazed by the drop and that they probably should not disinvest now. In fact, some of the best returns have been achieved by investing after a crash.

Even disinvesting from the market for very short periods of time can be detrimental to achieving good returns. Illustration B (click on one of the grey arrows underneath the picture to move between illustrations) shows by how much your return can fall if you miss out on some of the best days of the market. The orange bars show the returns that an investor would have achieved and is measured on the left vertical axis, while the green line shows by how much an investor’s overall return would fall and is measured on the right vertical axis.

For the 10 years to 30 September 2008, those who remained fully invested in the South African equity market would have achieved a return of 432 percent. If you missed the best 10 days your return drops by almost half to 220 percent and if you missed the best 30 days your return would have fallen to a meagre 56 percent over the entire 10-year period (which is less than 15 percent of the return that you would have got if you just remained invested in the market). It is amazing how quickly investors can diminish their achievable returns just by missing a few days in the market.

It is extremely difficult to outperform a simple buy and hold position

The second aspect of our work included a back-tested study which considered whether investors can beat the market by switching between equities and cash. We tested a variety of market timing strategies that investors might consider using and found that it is extremely difficult for any of these strategies to consistently outperform a simple buy and hold position. Using 40 years of data until 30 September 2008 it was found that more than 85 percent of investors achieved worse returns than a simple buy and hold strategy while almost 10 percent of them achieved returns even lower than cash (but with volatility similar to equities). Furthermore, if one factors in the cost of switching between equities and cash each time (as well as the effect of tax), the potential outperformance becomes even less likely.

Equities are an important asset class for long-term wealth creation, so any portfolio aiming for growth should have an equity component. This decision can only be made, however, after carefully considering your needs and circumstances with an expert as well as considering your ability to bear any losses. It is important that one understands the risks of making such investments and investors should not be fully invested in equities unless they are willing to maintain their position for at least seven years.