Price I would pay to know market bottoms
Updated: Feb 24
Is there a way your portfolio can return comparable returns to those of "God" of timing the market?
There is always a friend or a colleague (call him DIPS) who brags about his phenomenal returns on an investment he made at the market bottom and going at lengths on why did he predict it to be the bottom. A rule that smart passive investors follow and recommend is dollar-cost averaging. I wondered how would its return compare with that one person who waits patiently to time the market perfectly.
In dollar-cost averaging investment method, an investor invests a fixed amount say $500 in regular intervals systematically. SIPs or recurring investment vehicles typically invest with a philosophy of dollar-cost averaging investing.
Time Stock Price Invested # Shares Bought
1 100 100 1
2 80 100 1.25
3 125 100 0.8
In the table above, a dollar-cost averaging is shown at work. After three-time instances, I would have bought a total of 3.05 shares. But, one can wonder what if DIPS invested all his $300 at time 2. He would have ended up with 3.75 shares compared to my 3.05 shares. Quite a disappointing performance for me. Or is it? Let us put it to the test.
Investing in NIFTY50 (Indian stock market index)
I assume that investors have Rs. 500 to invest every month starting from the year 1993. I also only took the investment period till the end of 2017. Investors might choose to invest their money in Nifty50 or keep holding cash. Investors are entitled to a dividend yield of 1.5% for the shares they hold and their saving account gives them a return of 3%. These seem to me as reasonable, realistic, and conservative assumptions. The spreadsheet for my calculation can be found here.
To my surprise, DIPS doesn't really outperform the dollar averaging by a lot. Moreover, a study found that average investors do not reinvest their dividends. This is extremely devastating for their total returns. If these investors chose to also invest their dividends at rock bottoms only then they would actually be sitting with at par performance with dollar cost average investment!
Performing the same analysis in SNP500 strengthens my claim. I saw that DIPS actually underperformed. This is quite fascinating for me and shows the power of consistency here.
So you might be wondering what is really happening here. Rock bottoms are relative. When the price drops from 1000 to 500 then 500 might be like a bottom and a good price to buy whereas, when the price is going up from 100 to 200 then 200 seems to be an expensive price to buy the index. DIPS investor often keeps waiting for this rock bottom and doesn't invest in the index when it is rising. To make things worse, he loses out on dividend yields.
In reality, we are not DIPS investors who would know the exact rock bottom for the index. Hence, I believe there is extremely little value in waiting to time the market. However, you may choose to invest your money somewhere else such as real estate or some business opportunity where you can get higher returns than in a savings account and wait to time the stock market. But it doesn't make sense to hold cash for extended periods to wait for the 'right' entry price.
I would also like to re-emphasize that when you are holding cash for a long time to wait for the right opportunity, you forget that you lose out on the power of reinvesting dividend yields. I have elaborated more on this topic here.
So how much would I pay to know from GOD if it's the short-term rock bottom price? Not more than 2% management fees :P