Timing – Does it really matter? (Blog originally posted in April 2008)

o IMF says there are 25% of chances of a world recession
o US going through worse recession than 1929
o Soros says sub-prime losses could exceed $1 Trillion
o Indian inflation at 7%, Government worried
o World commodity markets on fire
o Oil past $105 a barrel, high oil prices to stay, says OPEC chief

Well, let us state the obvious – in the perennial financial yo-yo between greed and fear, the latter is clearly winning this round and investors are licking their wounds. With such headline news in the past couple of months and with the world stock markets being what they are ( with India and China “leading” from the front), the questions that we’d like to address are – how should investors react? Should they wait – for the recession to end or for the price of oil to come down or for rice or wheat or copper to be more affordable and so on? Is there a way to time the markets?

Answering this very question, over the years countless systems have been designed to make money in the stock market. They are inevitably constructed using historical data but as the likes of Long Term Capital Management (the company which employed Nobel prize winners and had MIT and Harvard professors on their rolls) discovered, models cannot predict everything. That’s probably because of two reasons. The first reason is, as Mark Twain said, history rhymes – it does not repeat. Secondly, what the models remove as outlier events (extremes which distort the general trends) often end up becoming realities (black swans).

Some experienced campaigners are humble enough to admit this shortcoming – Peter Lynch, the legendary head of Fidelity wrote in his book ‘Beating The Street’ about an annual gathering of the Barron’s roundtable, where a group of supposed experts debate about the various topics related to the stock market. He says that the year they were most optimistic about the future of the US economy and the stock market was 1987, which ended with the famous 1000 point drop. (In 4 trading sessions in Oct 1987, there was a 31% drop in the DJIA and the value of US Equities decreased by almost $1trillion – more than the current market cap of Indian equities). He adds, “Here is a group of influential professionals who manage billions of dollars that belong to other people, and from one Roundtable to the next we can’t agree on whether we are facing an imminent global depression or an economic swing.”

Before we move further, we’d just like to talk about a related topic – a part of the human psyche which has been built into our systems over the thousands of years of human existence – risk/ loss aversion.

This theory is based on certain experiments which were conducted and we will relate only to a part of the experiment here. A group of people were asked to choose between a sure gain of $100 or have someone flip a coin and give them $200 for heads and nothing for tails. Most people who were asked this question went for the sure $100. Let's see why. In a mathematical sense, a sure $100 and a fifty percent chance for $200 are equivalent. However, when a graph was built based on the responses, it was seen that an objective gain of say $100 may give 10 units of subjective satisfaction, but a gain of $200 won't give 20 units of satisfaction. Rather, one will feel only about 1.7 times as good. Hence, when the choice is between a sure gain and an uncertain, larger gain, the average person’s first choice would be to go for the sure gain.

On the reverse, Neuro-economics research shows that financial losses are processed in the same area of the brain which deals with mortal danger. People feel considerably more pain after incurring a financial loss than they do pleasure after achieving an equivalent gain.

Within the two aspects of loss aversion discussed above, perhaps lies the explanation as to why we want to be ‘sure’ about the timing before we enter the market.

Whenever there are biases, we are prone to take irrational decisions. So how should we react to all the negativity surrounding us today?

Lynch says, “Keeping the faith and stock-picking are normally not discussed in the same paragraph, but success in the latter depends on the former. You can be the world’s greatest expert on balance sheets or P/E ratios, but without faith, you’ll tend to believe the negative headlines”. He adds that whenever he is confronted with doubts and despair about the current Big Picture, he tries to concentrate on the Even Bigger Picture. The Even Bigger Picture tells us that over the last 70 years, stocks have provided their owners with higher gains than T Bills, bonds etc. And also that in the same 70 years, there have been 40 scary declines of 10 percent or more in the market. Of these 40 scary declines, 13 have been for 33 percent, which puts them in the category of terrifying declines.

He further adds that a decline in stocks is not a surprising event, it’s a recurring event. If you live in a cold climate, you expect freezing temperatures, so when your outdoor temperature to drop below zero, you don’t think of this as the beginning of the next Ice Age. You put on your Parka, throw salt on the walk, and remind yourself that by summertime it will warm outside.

Kenneth L. Fisher, in a book called “The only three questions that count”, wrote that the longer a bear market runs, the more likely it is that we will be waiting too long to get back in.

He says, “Further, if you get out successfully and time proves your success, your Stone-Age brain would like to keep you out until after that initial next bull market rocket ride. Staying out is more comfortable—it lets you feel right longer, particularly if you convince yourself the start of the rocket ride isn't real. Your brain wants to accumulate pride for having gotten out successfully. Switching back to bullish means you might be wrong and if you are people will ridicule you.”

“At market bottoms, bear markets do a V-bottom or sometimes a W-bottom. Think about the bottom like a V (or a W-if there is a double bottom). If you successfully get defensive sometime after the peak, does it matter which side of the V you get back in on? Not really.”

History has shown us that we are simply incapable of timing the market. Even the father of value investing, Ben Graham got it wrong – he was bearish when the Dow was only at 400 and had advised the young Warren Buffett to stay away from the market at that time. Furthermore, if one looks for the successful stock market investors, one will find that they had been long term stockholders in successful enterprises. Mr. Buffett is aware that great buys can show up even a raging bull market.

As regards the present negative headlines, well, the world has seen a fair share of them – sample the following: 1940: France falls to Hitler; Battle of Britain 1966: Vietnam War escalates-U.S. bombs Hanoi; highest price/debt ratio in a decade; 1969: Money tightens-markets fall; Prime rate at record high; 1973: Energy crisis-Arab oil embargo; Watergate scandal; 1974 Steepest market drop in four decades; Nixon resigns; Yen devalued; Franklin National Bank collapses; 2000: Dot-com Bubble begins to burst ; 2001: Recession, September 11th terrorist attacks; 2002: Corporate accounting scandals, Terrorism fears, Tensions with Iraq. Every time, it just SOUNDS like its different.

In 1979 when the Business Week ran a celebrated cover: “The Death of Equities”, it was a widely held view that the fact that shares were cheap was only proof of the fact that the market was not merely down but dead. Buffett strongly disagreed. In the same week, he penned an essay for Forbes saying, “The future is never clear; you pay a high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

So where does all this lead us? To the fact that it is not the timing but the Price that matters. Besides the kind of investment, it is the price which truly determines the rate of return on the investment. If a higher price has been paid for a fabulous company, then no matter what time you paid it, you are always at risk. Does it really matter if one buys a $1 bill for 50 cents and then the same $1 bill becomes 30 cents? We think not, because it only becomes more attractive, not less! Price, as Graham put it, is your greatest friend. We cannot live in the fear of cataclysmic events for ever. As per Lynch, the ‘penultimate preparedness’ is our way of making up for the fact that we didn’t see the last thing coming. Of course the great joke is that the next time is never like the last time.