Tuesday, 15 January 2008

Is it good to buy when the market is bad?

There always appears to be a good reason to avoid the stock market when it's in decline. Unfortunately those good reasons often turn out to be unfounded, just as the 'logic' behind a bubble market is always found to be insubstantial upon later reflection. After all, Nobel-laureate economist Paul Samuelson observed forty years ago that "the stock market had predicted nine of the last four recessions".

There have been numerous studies showing that very few (if any) people successfully time the market using skill and judgement (a few people will always get lucky when they try timing the market, or picking stocks, and usually write a book about it). And many more studies showing that your asset allocation has a much greater impact on your overall results than either timing or stock picking. However, it's always tempting to try to pick the best time to enter and exit the market. After all, it's all to obvious in hindsight when we could have done really, really well if we'd just bought and sold at the "right" times.

The current rapid drop in the Australian stock market of more than 10% made me wonder if this is a good opportunity to buy some more stocks. Although a rapid market drop actually increases the amount of "risk"(market volatility), it seems logical that if stocks were good value at $100 then they're even better value during a "10% off everything!" sale. Of course if something fundamental has changed to make the company less profitable in the future, then it's more of a clearance sale of shop-soiled seconds ;)

In an attempt to decide whether to buy some more stocks at this time I had a look at the past ten years closing price data for the All Ordinaries Index to see if buying when the market is down 10% or more from it's previous high would have been a good strategy. (Even if this back-testing showed a particular strategy was a winner, it doesn't mean that the same will hold true in the next ten years). I calculated the average 1-year, 2-year and 5-year returns for having bought on any day vs. the returns achieved if you'd only bought on days when the market was 10% or more off it's previous closing high.

bought any day bought only when
market down >=10%
average 1-year return 10.68% 1.83%
average 2-year return 21.12% 5.31%
average 5-year return 46.45% 10.60%

So, it appears that (at least during the past ten years) buying into the stock market on a day when it was at least 10% below it's previous high would have been a poor strategy. It would seem that this strategy would have meant you didn't buy during the extended bull run periods, and when the market was down more than 10% it was often entering into a bear market. Although this is a very superficial look at a limited amount of market data, it has somewhat dampened my enthusiasm for increasing my stock investment in the current market.

Copyright Enough Wealth 2007

1 comment:

Contrarian Investors' Journal said...

Yes, we believe you've made a wise decision to wait and see for now. If we are now at the turning point of the economic cycle (i.e. company profits will at that point start to trend down), then buying now will prove expensive in the future. Many people fails to see economic turning points and have to pay for it (see Common mistakes in failing to see economic turning points).