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Buy the dip?
16 Feb 2022
From crippling inflation that causes central banks to tighten their interest rate policies to tensions in Ukraine, investors have a lot to ponder at the turn of the year. Thus far sentiment has generally pushed markets down, which is bad news for those who are fully invested but might be an opportunity for those brave or foolish enough to try and time the market. In this newsletter we will try to answer the question whether it historically made sense to buy the dip or if a cost-averaging strategy tended to perform better.
For this experiment we create two portfolios, who use different strategies during ten-year holding periods, starting from 1930 onwards. The returns on bonds and equity investments are taken from Kenneth French’s data library and relate to the United States.
- A cost-averaging portfolio: In this case we simply invest 100 EUR at the beginning of each month in the stock market.
- A timing portfolio: Here we invest 60 EUR in stocks and 40 EUR in bonds on a monthly basis. When the equity market experienced a drop of more than 20% over the preceding year then all bonds are sold and this amount is put into equity. The results of the simulation are summarised below.
The table shows that – most of the time – trying to time the market did not result in a higher internal rate of return. In just two out of nine decades the timing strategy actually (barely) outperformed the cost-averaging strategy. This includes the sixties, when interest rates on bonds rivalled equity returns, as well as around the turn of the century when the timing strategy partially avoided the dotcom bubble and the financial crisis.
Of course, return is just one metric. An advantage of the timing strategy is that it has substantially less risky (lower drawdown and volatility) as it tends to invest a significant part of the portfolio into bonds. Yet, it is clear that if you are aiming for the highest returns possible then trying to time the market generally will not help you.
As a sidenote it is comforting to know that over each decade the IRR was positive for both the cost averaging and market timing strategy. A total investment of 12,000 EUR grew to 15,668 EUR in the worst-case scenario and 28,007 EUR in the best-case scenario. So perhaps the most important lesson of this exercise is that, whatever method you prefer, investing always pays.
Despite the sharp increase in market volatility our funds held their own in January. Vector Navigator fell by 2.34% during the month, outperforming the Morningstar category by 2.77%. Due to a combination of its market hedge (~50%) and its stock selection alpha Vector Flexible even recorded a small gain of 0.34% in January, beating its competitors by a wide margin of 3.87%.
Werner, Thierry & Nils