Since the bull market has been amusing us for over 5 years now, more and more analyst keep predicting market corrections. Of course smaller corrections have happened in the last few years but big corrections, let’s say at least 20%, have been rare to absent.
While I am 100% convinced we will see a 20% correction someday I have very little clue as to when exactly this might be. Should I anticipate and act now based on the assumption we will see a 20% market drop in 1,2,3 or 4 or even 5 years from now?
If I decide to wait with further investments and put the money in cash (euro’s or dollars) I will lose out on the dividend and most likely the growth for a couple years until the correction comes at which point I will be able to use my cash position to buy stocks 20% cheaper. However 20% cheaper than what? 20% cheaper than the month or week before the crash, which might be 30% above the market right now!
So this is pretty difficult to anticipate, as a thought experiment I am going to assume the market will drop about 20% somewhere in 2016, which is pretty much a worst case scenario when you are planning on starting big positions in 2015.
Waiting can be Expensive
When the market is at 100 right now it will probably grow 5 or 10% until the anticipated correction comes in 2016 and at the same time pay me a 3% dividend. So when favoring cash over stocks from now until the correction I am missing out on 8% to 13% gains in the meantime. Is this 8 to 13% ‘loss’ worth the possible 20% cheaper entry point?
It gets even worse when the 20% correction takes a two-year wait or more. If I decide to wait and it turns out that it takes until 2017 to see this next big correction I have then missed out on 6% in dividends and possibly 10% to 20% growth.
|20% Correction in||Missed Gain||Cheaper Entry||Net|
|… 1 year||8%||20%||+12%|
|… 2 year||17%||20%||+3%|
|… 3 year||26%||20%||-6%|
|… 4 year||36%||20%||-16%|
|… 5 year||47%||20%||-27%|
Of course the figures vary heavily depending on the estimates that you make. If you consider just 5% return per year and you expect a 30% correction within one or two years there is a lot more to gain by waiting.
However as you can see the first year missed gain is just 8%, this grows to 9% in the second year and even 11% in the fifth year because of the compounding effect.
All these figures are rounded down and not very exact, the insight I have gained here however remains that is very difficult to make up for lost time.
Can you Time the Market?
There is one more added factor that I did not take into account but which most likely further decreases your return when you are waiting for a correction. That is the aspect of timing. When the market corrects, what are the odds you will actually pick the exact bottom?
Even though it is clear to me that waiting for a correction is most likely not in my own best interest there is a reason investors might be inclined to do so. It might give you great comfort knowing that you have build up a cash position which can profit from any great dip. When it will help you sleep at night who would blame you for hoarding some cash!