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Investment Strategy
Thursday, January 1, 2009
The cost of impatience

Investors, who believe they can time the markets successfully, have less than a 10% chance of outperforming a long-term buy-and-hold strategy.

John Kinsley, Chief Operating Officer of Prudential Portfolio Managers (SA), says recent research conducted by his company shows conclusively that while holding on to your equity investments over the longer-term may require you to stomach severe rollercoaster rides from time to time, you are likely to outperform a market timing strategy more than 90% of the time.
“It is extremely unlikely that an investor will have the luck and fortitude to execute a timing strategy in such a way as to buy into equities at the bottom and sell into cash at the top of the market all the time. Getting that timing correct is extremely difficult, if not impossible, apart from by chance.”
Kinsley says investment trends continue to show that investors still believe that they can time the market, making emotional investment decisions based on either fear or greed.
“Severe market volatility significantly increases the temptation to time the markets, with investors finding it almost impossible to watch their equity investments bleed, while cash is offering attractive returns.”
Therefore, with the aim of proving to investors just how dangerous a market timing strategy is, Prudential’s quantitative analyst, Clare Johnson, performed a market timing simulation using weekly return data from 1986 to 2008. The following assumptions were made:
• The asset classes under consideration are equities and cash.
• The investor may perform up to 50 switches during the 22 year period.
• There is a transaction cost of 50 basis points (0.5%) per switch.

Johnson says 100-million possible switching transactions were simulated, moving between equities and cash at various periods.
“While this is a fraction of all the possible switches that an investor could have executed, this still represents a large enough set of scenarios to provide a good indication of whether switching strategies are likely to enhance returns or not.”


The histogram depicts the outcome of the simulation. The horizontal axis shows the range of realised returns, and the vertical axis shows what proportion of switches achieved the returns. The blue line indicates the 13.2% return that would have been achieved if no switches had taken place. On the right of the blue line are those switching strategies that did particularly well. The vast majority of the strategies, however, are on the left hand side – the switching strategies that lost money as a result of transaction costs, and because the timing was wrong.
Distribution of annualised total return outcomes for 100 million different equity/cash switching strategies
Kinsley says the simulation exercise clearly shows that frequent switching erodes total returns and seriously damages investment performance in the long run.
He therefore encourages investors to take emotions out of investing and to, with the help of a trusted financial adviser, take long-term investment decisions that have the potential to deliver superior returns over time.

Copyright © Insurance Times and Investments® Vol:22.1 1st January, 2009
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