Time In The Market, Not Timing The Market

If you’re a client of Nexus – or have ever sat through a presentation of ours – you will have inevitably heard our mantra: The keys to long-term financial success are: keep it simple, control risk and avoid short-term distractions.

Recently, we had a live example of a situation apropos this gospel, when one’s ability to look past a myriad of short-term distractions was put to the test. In Q4 2018, in the face of geopolitical worries, economic concerns and many other unsettling developments, equity markets suffered an award-winning swoon that included the worst December since the Great Depression for the Dow Jones Industrial Index. Both the S&P 500 and the TSX Composite had similar experiences (see the chart below).

During bouts of volatility such as this, many investors find appealing the notion that they can get out when it’s “risky”, and then back in when it’s “safe”.  This belief in timing markets runs counter to long-term success and has kept many investors underinvested during the market’s subsequent recovery.

Consider an investor who happened to be sitting with cash on the sidelines in 2018. They likely breathed a sigh of relief as markets fell in the final weeks of the year. But unless they had powers of clairvoyance, it is highly improbable that such an investor jumped into the market in January. And why should they have? The concerns that troubled the market in December were no better in January and in fact remain worries today.

The problems with “timing the markets” are many. It is not just about trying to get out, but also about getting back in. Despite ample academic evidence that it is counter-productive to long-term financial success, some investors still see market timing as a viable means of managing money.

At Nexus, our belief is to stick to a philosophy and process that has been proven over more than 30 years to withstand the bumps and grinds of equity volatility. Using this approach we have produced solid absolute and relative returns, thereby creating actual wealth for our clients over time. We believe that the key is to identify quality companies with both growth and defensive characteristics. We don’t always expect our portfolios to outperform the market, particularly when it’s off on a speculative tear. We’re indeed delighted that we have been able to match, on average, the market during periods of positive performance in the past (see the chart below). But we do expect our portfolios to weather the downturns better; i.e., fall less than the market in a decline, thereby providing a higher starting point for the inevitable subsequent correction. In this, we have delivered a very attractive up- and down-market capture profile. This “ratchet effect”, if consistently produced, will result in better returns than the market over the long run, without the risk that comes from a market timing approach.

Why do we believe this so fervently? It’s actually quite straightforward. A stock’s total return can be broken down as follows:

Dividends + Earnings Growth + Valuation Change + Currency Effect = Total Return

This is true for both short and long periods, but the drivers of the total return differ in magnitude between the short term and long term. As shown in the 1-Year Return chart below, over short periods, emotionally-driven factors, such as valuation changes and currency effects, have a large influence on return. Valuations change with the sentiment of the day – fear and greed.  Similarly, currency effects are notoriously hard to predict as currency swings are heavily influenced by emotionally-driven investor flows. This is short-term market “noise”.

Over the long term, however, it’s a very different story! Long-term returns are driven by company fundamentals (see the S&P 500 15-Year Annual Return chart below). Dividends, which are generally predictable and consistent, contribute a significant and stable portion of the long-term return. But it is earnings growth that makes the largest contribution to returns. Over longer periods, valuation changes and currency effects matter very little as the short-term ups and downs tend to cancel out. To repeat, long-term returns are driven almost entirely by dividends and earnings growth. Not surprisingly, these are two factors that Nexus evaluates carefully when analyzing companies (along with making sure we are not overpaying on valuation, of course). Selecting securities using a disciplined investment approach incorporating these factors will produce tangible, long-term benefits.

Summary

“In the short run, the market is a voting machine but in the long run it is a weighing machine” – Ben Graham

As investors, we must accept that we cannot predict with any shred of certainty geopolitical events, currency fluctuations and short-term market movements. But, an investor can successfully identify well-run companies that have consistently proven that they can manage through economic, political and market gyrations, thus delivering value to the shareholder in the form of earnings growth and dividends. This is key: the driver of long-term success – quality companies identified by a disciplined investment approach – is independent of short-term volatility.

What else can an investor do? Realize that market fluctuations are normal and pay less attention to this short-term “noise”. Avoiding short-term volatility is impossible. But, sticking to a long-term plan is doable. Accept the fact that over a 25-30 year horizon, you will experience many weak periods. It can be very tempting at certain points to move to the sidelines and wait for that next “buying opportunity”. The solution to making that “leap” into the market, however, is not through any market timing “strategy.” Rather, it is through establishing a program for getting invested and sticking to it. You don’t need to get in all at once. But, in order to get the long-term benefit of stocks, you do need to get “in” – and stay “in”.