Waiting for a crash suffers from two problems.
Firstly, markets tend to be trending more than risk adjusting. Markets historically do not dip deep enough (the kind of dip everyone was expecting) for us to meaningfully profit from the crash.
Secondly, there is risk and therefore we hope that the market compensates us for the return. The premium that we can earn, in excess of the risk-free rate (also called the risk premium), has historically been high. If we sit in cash, we lose this.
A long time ago, I bring to your attention the performance of a buy-and-hold investor compared to a market-timer (read If you buy near market bottoms, you should do better than Buy and Hold right?).
The market-timer wins out, but not by much if you considered the effort. (of course, there are some nuances. Even though the annualized returns are 1-2%, these returns do result in a big impact when compounded over long periods of time).
The interesting thing about the research in my article was that the researcher went through this study with many different markets. The results were quite consistent across different stock markets.
Back in 2017, SVRN Asset Management gave some quantiative figures why waiting to buy the dip is a terrible strategy.
They simulated different ways you could wait for a dip and buy, and then sell over different time frames.
For example, you could wait until the market dips 10%, then you purchase. You would sell once your investments made it back to all time highs.
The chart above compares the cumulative excess (basically returns over cash) of a particular buy-the-dip strategy versus buy-and-hold.
The data of the return:
The annualized returns of the Buy-the-Dip strategy was much lower than Buy-and-Hold. A higher standard deviation means the returns of the strategy can be more volatile, relative to the average return. The Buy-the-Dip definitely is less volatile.
But less volatile can be a bad thing because there are downwards volatility but there are also upwards volatility.
The Sharpe Ratio shows the returns per unit risk. Sharpe Ratio allows us to put into context the relationship of volatility and returns. A Sharpe Ratio of 0.14 means for 1% change in volatility, this would have yielded 0.14% in returns. The higher the Sharpe Ratio the better.
It seems Buy-and-Hold is better.
However, some of you would wonder whether there will be a situation when Buy-the-Dip is better.
SVRN laid that out as well.
They back tested the date from 1926 to 2016 over different drawdowns ( a 10% drawdown to 50% drawdown) and then holding over different durations (1 year, 3 years, 5 years)
It seems from the data, waiting for a 10-15% drawdown and 40-50% drawdown will yield you higher Sharpe Ratios.
The excess returns if you buy the dip over 20 to 35% drawdown is lower.
We also observe that the excess returns rises when the holding period is longer.
The data tells me:
- Almost all the Sharpe ratios and Annualized returns of different drawdown durations and holding periods were much worse than the buy-and-hold (6.3% a year and 0.34)
- Holding period is important. The time in the market allows us to capture the risk premiums
- If we want to wait for a big crash, it would still be worth it. But the crash has to be a big enough one. However, usually those crashes occur once every 20 to 30 years.
- But then again, we already have 2 greater than 35% crashes in the last 12 years. Still, according to this data, the Sharpe ratio of waiting for 35% crashes might not be better than a small dip
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