Should I stay or should I go?

November 03, 2022 | The Simbul-Lezon Wealth Management Group


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Financial markets have been exceptionally volatile this year, with increasing calls for a recession in U.S. and Canada at some point in 2023. In such an environment, you may be questioning the merits of staying invested or putting new money to work.

Should I stay or should I go now?
Should I stay or should I go now?
If I go, there will be trouble
And if I stay will it be double
So come on and let me know

These lyrics from The Clash's 1982 hit song may be running through your head this year as you look at your statements and wonder "should I stay or should I go?" When this song was charting was also around the last time inflation was similarly high as it is today. In light of the ongoing volatility this year, we take a step back to look at the long-term and reaffirm the benefits of staying invested vs "timing the market". 

"Timing the market" vs "Time in the market" 

This is something you've likely heard us say many times, especially during the last couple years of elevated volatility. The topic of timing is something that challenges most investors and you may get worried as volatility picks up and equity markets swoon 2% or 3% seemingly every day. These are the times when you may panic and are more likely to consider selling, rather than putting new money to work. There can also be a degree of fear around deploying cash, which can become paralyzing and cause you to remain on the sidelines in the hope of deploying cash when the market bottoms. Our analysis shows that staying disciplined and "on-plan" at such times is important, and over the long term the benefit of perfectly timing the market bottoms is not as great as it may seem. As Sir John Templeton once said, "the best time to invest in the market is when you have the money."

In Exhibit 1, we look at the returns of three investors who started investing in 1989. Each investor started with a $10,000 investment in the S&P 500 index on December 31st, 1989, and from there on each person contributed $1,200 annually to their investment, but in very different ways.

Investor 1: The first investor is a perfect market timer. This individual has superhuman predictive abilities and can time their $1,200 annual investment each and every year at the corresponding market low.

Investor 2: The second investor is the opposite of the first. In their attempts to time they market, they get it perfectly wrong each year and invest their annual $1,200 contribution at the corresponding market high.

Investor 3: This person is a systematic investor, and rather than try to time the market they simply make their $1,200 annual contribution to their portfolio in the first month of every year. 

Exhibit 1: Time in the market is an important driver of returns

The first thing that stands out when we look at the above chart is how relatively small the difference is between the three portfolio ending values. The difference between the investor that executed perfect market timing compared to the investor that had perfectly mistimed the market is about 14% (over a 33 year period). On an annual basis, this translates to a 0.4% difference in performance each year. Also keep in mind that this scenario illustrates the worst case possible. In practice, it is virtually impossible that an investor would ever be able to perfectly time or mistime the market over a period of 33 years. If we compare the difference in market value between perfect market timing, and the systematic approach, the divergence in ending portfolio values is even smaller at 5.9%, or 0.18% annually.

The above results can be surprising (especially the small magnitude in divergence of returns), but they shake out this way because of the power of compounding returns over a long period of time. Mathematically the effect of compounding is a much more meaningful determinant of long-run returns compared to the impact that timing decisions have. In the short run, the market is going to do what it is going to do. Over the long-run, having a seat at the table (i.e. being invested) is what really matters.

Missing the best days of the market yields sub-optimal results

Investors often have the desire to beat the market by timing their buy and sell decisions. This could include selling stocks in anticipation of a market decline, or keeping cash on the sidelines with the hope of putting it to work when market bottoms. But seasoned investors will tell you that this approach is indeed very difficult to execute, and to pull it off you need to be right on three different occasions.

1) Avoid selling as the market continues to move higher.

2) Time the top, and sell.

3) Time the re-entry at the bottom, and buy.

It is hard enough to do one of the above, let alone all three, and generating consistent returns through market timing is seldom achieved. Moreover, it is also interesting to note that typically the best up days in a year come after very negative trading days, and missing the 10 best days (in pursuit of timing the markets) can results in sub-optimal performance. It is worth reminding that the only way to participate in the 10 best trading days is to remain invested while the only way to guarantee missing the worst days is to not invest in equities at all. The chart below (Exhibit 2) highlights the benefit of staying disciplined and staying fully invested, which can help clients achieve their long-term objectives.

Exhibit 2: Missing 10 best days in a year - S&P 500 and TSX

Short term noise vs long term value

One of the main challenges equity investors face when assessing the merits of an investment is separating short term noise from long term value drivers of a company. As the well-known investor Benjamin Graham once noted, "in the short run, the market behaves like a voting machine, but in the long run it is a weighing machine". Indeed, over the short term the share price of a company can swing based on how popular or unpopular it appears at that time. When markets behave like a voting machine, they can ignore long term business fundamentals and are driven by fear, greed, speculation and other factors.

So how do you assess the long term value of a company? Some investors rely on discounted cash flow (DCF) analysis, which projects a company's cash flows well into the future, to determine the value of these cash flows in today's dollars. While forecasting a company's profits 5 or 10 years from now is a difficult endeavor (let alone forecasting for next 1 or 2 years), it does provide a good framework to determine what a company might be worth today. Without getting into too many technical details, as the chart below shows, under this approach about 6.5% of a firm's value is driven by cash flows in year 1. This rises to 12.9% of the firm's value after year 2.

Exhibit 3:

As you can see, a couple of bad years where profits may be impacted doesn't materially affect long term value of the company. It is far more important to assess the quality and longevity of these cash flows as ~70% of the company's value is determined by cash flows that will come after year 5. Consequently, the question to ask yourself is why anybody would sell a good business, in view of short term risks, if majority of its value will accrue many years into the future. This is where the quality of the business (i.e. its business model, competitive advantages, strength of the balance sheet, etc) becomes an important consideration.

Invest in companies that can stand the test of time

Great compounders are extremely hard to find, and it is usually a mistake to sell them. This is especially true if the intention is to buy back the stock at a cheaper price further down the line. You may never get the opportunity to buy it back at a better price! If you were to ask friends or family who are business owners whether they would sell their business due to one or two bad years, the answer would most likely be a resounding no. A similar approach can be applied when discussing quality companies and investments in our portfolios, with the underlying message being “own a piece of the business, don't trade it”.

Should you have any questions, please feel free to reach out.


Your investment team

Marita Simbul-Lezon
marita.simbul-lezon@rbc.com
905-738-3244
Mary Rose Simbul
maryrose.simbul@rbc.com
905-738-3255
George Tsolakidis
george.tsolakidis@rbc.com
905-764-4846
Scott Donovan
scott.donovan@rbc.com
905-764-3283

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