At any point in time the stock market can either go up, stay at current levels, or decline. However, over time the stock market has an upward bias. During the last twenty years the TSX/S&P Composite Index has increased annually 8.19 per cent in spite of volatility during this period. When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens. It sounds easy when you’re looking in the rear view mirror. 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. Wilson has $1,000,000 invested and is currently earning $40,000 in annual income from dividends and interest. In addition to this income, Mr. Wilson’s investments fluctuate in value based on the markets which create either capital gains or losses.
Mr. Wilson decided that he wanted to be a market timer. By market timer, I 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. Wilson sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $12,500 per year, assuming that savings accounts are earning 1.25 per cent. The downside to savings accounts is that interest income is fully taxable each year. Mr. Wilson currently has the majority of his investments earning tax efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 2.75 per cent (4.00 – 1.25). For purposes of this article, we have assumed that both interest income and dividend income are equal.
Mr. Wilson 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. Wilson 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. Wilson will immediately see his income drop $27,500 a year ($40,000 – $12,500). The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. Wilson. Has Mr. Wilson made the right choice to liquidate? If the markets increase then Mr. Wilson clearly made a mistake. If the markets remain flat then Mr. Wilson still made a mistake as his income will drop $27,500 a year.
If the stock market goes down it’s not necessarily a given that Mr. Wilson will benefit from having liquidated his account. If Mr. Wilson makes a correct prediction that the stock market declines then for him to benefit he has to 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. Wilson does not have the insight to buy back in (before it rises back to the level that Mr Wilson originally sold at) then he would still be worse off. In essence Mr. Wilson has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.
Mr. Wilson should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs and no tax impact to the trades for simplification purposes. The difference between the current income Mr. Wilson is earning of 4.0 per cent and the new income of 1.25 per cent if he converts everything to cash is 2.75 per cent. Depending on how long Mr. Wilson is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful. Let’s assume that Mr. Wilson waits six months, one year, two years, and three years before buying back into the stock market. If every year Mr. Wilson is losing 2.75 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point the markets would have to decline 1.38 per cent (2.75 x .5) or greater, at the one year point the markets would have to decline 2.75 per cent (2.75 x 1) or greater, at the two year point the markets would have to decline 5.5 per cent (2.75 x 2) or greater, and at the three year point the markets would have to decline 8.25 per cent (2.75 x 3) or greater.
Making two right short term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem.