March 21, 2010

Buy Low and Sell High... Or Lose Most of Your Money Trying To

If you can buy low and sell high you'll make money.   If you do everything just right then you can profit greatly off the market ups and downs.   But that is easier said than done.   It seems human nature that we let emotions get the best of us and we might buy or sell for the wrong reasons.   If you do everything wrong you can lose your shirt.   To illustrate just how much good or bad timing can impact your returns lets look at an example of starting with $10,000 and investing over the past 15 years in the S&P 500.

This is what the S&P 500 looked like at the start of January for the past 15 years:

( note: These are the 'adjusted close' numbers reported off Yahoo finance which includes dividends.   This is not a perfect reflection of all highs/lows of the S&P 500 but just a periodic snapshot of the value at the start of January.   I was being lazy and just grabbed a easy set of numbers.  This is not meant to be super realistic, I'm just making an example here.)

You can see it has been a bit of a roller coaster.  It first went up, then it went down, then up again, then down, and finally its recently being going up again.   What if you'd been smart or lucky and bought at the lows and sold at the highs?   How about if you'd timed things poorly and bought at the peaks and sold at the lows?      Lets look at a worst case and best case scenario.

Bad timing:
Sit on the sideline from 1995 to 2000.
Buy at peak in 2000 - S&P500 at 1394 : Your $10,000 gets you about 7.2 shares.
Sell at a low in 2003 - S&P500 at 855 :  Cash in your 7.2 shares for $6,136
Buy at the next peak in 2007 - S&P500 at 1438 :  Take your $6,136 and get 4.3 shares.
Sell at the low in 2009 - S&P500 at 825 : Cash in your 4.3 shares for $3,524
Start with $10,000 in 1995 and end up with $3,524 in 2009.   Thats a 64.7% loss.
This is a -6.7% annual compound growth rate over 15 years.

This person with very bad timing has managed to buy at the very worst times and then sold at the worst times.  This isn't all that of an unrealistic scenario.  People see the market going up so they decide to jump in.  They don't notice it going up initially so they miss half the gains.  Then by the time they take action the market has basically peaked and they jump on the bandwagon when its too late and they buy at a high.   Then the market starts to plummet and they start losing all their money.   They're afraid of losing more so they panic and pull everything out after the plummet and sell at the low.

Good timing: 
Buy in 1995 - S&P 500 at 470 : Your $10,000 gets you 21.2 shares
Sell in 2000 - S&P500 at 1394 : Sell your 21.2 shares for $29,643

Buy at a low in 2003 - S&P500 at 855 : Buy 34.6 shares with your $29,643
Sell at the next peak in 2007 - S&P500 at 1438 : Sell the 34.6 shares for $49,823
Buy at the low in 2009 - S&P500 at 825 : Buy 60.33 shares with your cash
End 2010 with  60.3 shares worth about $64,784
Start with $10,000 in 1995 and end up with $64,784 in 2010.  This is 547% growth.
That is a 13.3% annual compound growth rate for the 15 year period.

Now compare that to a passive investment strategy of simply buying and holding for the entire 15 year period.

This is a less realistic scenario.   But if you're smart or lucky or a combination of both then you could possibly accomplish this.  To put it in perspective however, the great Warren Buffet saw his Berkshire Hathaway grow from about 24k a share in 1995 to 122k per share today.   So Berkshire grew about 11.4% annually in that period.   Its not too realistic to think many people are smart or lucky enough to beat Buffet's performance over a 15 period.

Buy and Hold
Buy in 1995 - S&P at 470 : Your $10,000 gets you 21.2 shares
End 2010 with 21.2 shares worth $22,828.  
Start with $10,000 in 1995 and end up with $22,828 in 2010.  That is 128% growth.
Over 15 years this is a 5.8% annual compound growth rate.

Doing nothing but sitting on an investment for 15 easily beat the failed market timing by over 12% a year.   This isn't nearly as good as the 13% gains from buy low and sell high good timing.  But considering that the market was essentially flat for the past 10 years getting a 5.8% annual gain out of the 15 year period is pretty good.

Now to be clear this is all made up examples based on S&P ups and down.   I don't expect people trying to time the market will limit themselves to buying on the 1st of January once a year.   And the numbers I used include dividends and someone buying and selling will see much less of an impact from dividends.

The bottom line:    Yes you can make gobs of money if you time the market perfectly.   But that is not very likely.   I think most people are much more likely to time the market poorly and lose most of their money doing so.

Blog Widget by LinkWithin