Wednesday, January 12, 2011

Next time I won’t sell!

New Year is the time of resolutions. "From now on I will do better", you say. Yet the average investor seems always to buy high and sell low. This weekend I read the statistic that over the last 20 years ending in 2009, the average equity fund investor made a ROI of 3.17% while those who stuck with the S&P500 through thick and thin made 8.2%. Why is this?

The average investor buys near market highs. Doug Ramsey, a U.S. investment researcher found that most investors bought when the market's P/E ratio (stock Price divided by that year's Earnings) is 21 and they sell when it is 14. Now think about this! Assume earnings don't change over time (not likely) so the investor buys $1 earnings for $21 and then sells it for $14. That is a loss of $7 or 30%! Oh boy, how do you make money that way? Everyone knows you should buy exactly the opposite way!

The true investment genius is the one who buys at $14 and then sells at $21 and... does this over and over again! That is the idea behind market timing. Guess what, nobody has consistently executed market timing. Even investor-extraordinaire Peter Lynch stated that he didn't see the 1987 October crash coming! In fact, he was on vacation, blissfully unprepared for the event. When we learn more and more about investing, we learn that over the long term market fundamentals such as earnings and earnings growth determine the value of a stock; while over the short term it is the market psychology (fashionable bulls and bears, panic sellers and buyers) rule. Day traders use technical analysis to help them profit from market psychology as do momentum investors, but only the most nimble ones appear to win. The best way is to buy when the price is right and then to hold on for a long, long time.

You may have seen this 'wisdoms' written in numerous investment write ups, but is this truly so? Well apart from the real end of the world, the end of capitalism or some other act of God, the answer is yes. No-one can see into the future but the power of an Excel spreadsheet with a random number generator is truly awesome! Yes, it is AWESOME!!!!

I simulated THE MARKET 30 years into the future. From past posts and from other authors, or even from personal observation, you may be aware that the market appreciates over time and that if you reinvest your dividends then according to Jeremy Siegel, over the long term you'll make around 11.2% annually. Market value fluctuates around an average rate of appreciations. In an previous post we noticed that over the last decades, markets crash from their peaks around 45% and increase 145% or so from the through to the next peak. That is why we predicted here on this blog that the TSX is likely to reach 18,000 over the next 3 to 4 years and then will likely crash again. Just dumb extrapolation! Will this really be the case? How the heck should I know? But it sounds like a good guess to me.

 Figure 1. Scenario 1 – with purchase at average market index valuation of 100
The ups and downs of stock markets are by many investors considered to represent 'risk', but if you are not forced to sell at a low and if you don't only buy at market peaks, these things are meaningless until the day you sell (or buy). If you just hang on, the value of your stocks will revert to the average market price. This average price will increase over time due to profit growth, economic growth and inflation. Starting with a market index of 100 where market prices fluctuate randomly from 30% below the average market price to 70% above it and with a time horizon of 30 years we can simulate the market on our spreadsheet. Assuming a dividend yield of 3.5% that dividend payments increase with inflation; an average inflation rate of 4% per year; and Jeremy Siegel's long term overall stock return of 11.2%, we reiterated typical annual index appreciation.

Based on the previous assumptions, the index has to appreciate on an average annual rate of 10%. The blue line on the graph in figure 1 shows you such a market index value trajectory. I fixed the final index value is at 1744.94 after 31 years based on 10% appreciation. In real life, after 30 years investing you don't cash in during a market low – you can wait 6 months or longer until you are at least at the averaged market price or better when the market is approaching a peak. Hence I fixed the final index value at the end of the simulation.

Whenever you press <F9> the spreadsheet recalculates the results and creates a new stock market 30 year scenario that starts with an index value of 100 and ends it at 1744.94. In between you see a continuous changing succession of market highs and lows alternating every 2 to 5 years, just like the real market. It is hilarious, just like the rope we squiggled when playing as kids. Upon pressing press <F9> in quick succession it looks like a movie of an undulating rope of which the end points (100 and 1744.94) are fixed. Just like in the real world, the ups and downs don't matter; the only things that matter are the starting value and the end value.

The second line on the graph represents the value of a stock portfolio invested in an ETF following the simulated market index. The ETF pays a dividend that started out at a yield of 3.5% or $3.50 annually. The dividend increases annually with inflation like the real world. The dividends are reinvested each year in the ETF at that year's price. So if the market peaks and the ETF is priced high you buy only a few expensive shares while during years of low valuation you buy more cheap shares. The orange line represents the portfolio value over time. It fluctuates just like the index but it outperforms the index more and more. After 30 years, the reinvested dividends represent close to 40% of the portfolio's value. That is why so many investors love DRIPs (Dividend Re-Investment Programs).

The spreadsheet calculates your portfolio value after 30 years. Every time you push <F9> and a new 30 year stock scenario ripples from start to end along the stock index valuation 'rope' (figure 2) and the returns for your DRIP portfolio are calculated. I pushed the button 20 times (20 stock market scenarios) and calculated how many total shares were accumulated and the portfolio's value based on the fixed end value of the index (1744.94). The results were enlightening. The average ROI for these 20 scenarios each lasting 30 years was 11.29% (not surprising because we tried to emulate Jeremy Siegel's 200 year average ROI on U.S. stocks), but the real surprise was the consistency of the ROIs. The 11.29% ROI for 20 scenarios showed a standard deviation of barely 0.1%. The portfolio's end value ranged from a minimum of $2652 to $2914 based on an initial investment of $100. 35.6% to 41.55% of the profits were the result of dividend reinvestment!

Figure 2. Another Scenario – with purchase at average market index valuation of 100
So, no matter what happened during the years in between, once invested you would make the long term average return typical for the stock market. If you panicked and sold out during a downturn your results would be a lot poorer. So it is only the beginning, the end and the average market appreciation over the long term that determine the success of your investment. But does it matter at what price you buy? The answer is... yes... to some degree.

Suppose you bought the shares at below average market value during a down turn, what would that do to your return? In our simulation, we 'bought' 20% below the average market value. So instead of buying $100 worth of stock when the index stood at $100, we bought during a downturn when the index stood at 80. Thus instead of buying 1 share we bought 1.25 shares for $100. The annual return of investment improved from 11.29% to 12.1% and with a standard deviation of less than 0.1%. In absolute dollars, the portfolio's end value was on average $3,451 versus $2753 if bought at average market valuation. If bought at a market peak (20% above average market valuation) ROI dropped to 10.32% again with a standard deviation of less than 0.1% and a final portfolio value of $2098 (on average).

So, when investing in the stock market, the price at which you buy is important, a difference $1,353 in profits between a purchase bought during a downturn or near the peak of a bull market is substantial when compared to the total profit of $3,451. But once out of the gates, it is just like riding bronco; you just hold on and you will make your profits. If you get thrown off and sell in a panic, you lose! Market timing is impossible, but an avid investor should be able to judge whether he is buying an overvalued stock or whether he is buying one that is undervalued. Your innards may be churning during a down turn when buying the stock index or a diversified portfolio of undervalued stocks of quality companies, but that is how above average profits are made not by running along with the herd and buying in an overheated stock market along with the masses.

Figure 3. Scenario 1 – with purchase at 20% below average market index valuation of 100 (compare portfolio value with figure 1)

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