Most people are familiar with the saying that “time in the market is more important than timing the market”. It is very true that holding a quality investment for many decades will mask imperfect timing. However, for some asset classes/investments, timing can be very important.
Most markets move in cycles
Most people understand that markets move in cycles. To generalise, an asset class can be over-valued (particularly during a boom cycle), under-valued (after a bust cycle) or fairly valued.
If you had have invested in the US tech index (NASDAQ) in November 2021 you would have lost about 30% to date. This is a lesson in poor timing. $100 invested would now be worth $70. An investor needs a 43% return just to get back to $100 again (breakeven). It’s worth noting that every fundamental indicator highlighted that the NASDAQ has been overvalued for some time. Of course, a bull market can last a lot longer than anyone can anticipate which invites people to ignore these fundamental indicators.
Mean reversion: what goes up, must come down
If we acknowledge that most markets move in cycles, then it is obvious that we should invest in undervalued or fairly valued asset classes and sell asset classes that are overvalued. Taking this approach leverages the power of mean reversion as I explain in this blog.
Investment-grade property has much flatter cycles
It is important to define what I mean by “investment-grade property”. Investment-grade property is an asset that has produced a solid historical capital growth rate, underpinned by a strong land value component and scarcity. As such, investment-grade property benefits from perpetually strong demand at a level that exceeds supply. These assets are generally located in well-established, sort after, blue-chip suburbs.
Property is a lot less volatile than shares – about half the rate. I suspect there’s two reasons for this. Firstly, property is a necessity. We all need a roof over our heads. It is not a discretionary asset, like shares are. Secondly, due to high transactional costs (agent fees, stamp duty, etc.), property isn’t traded (bought and sold) in the same way shares are.
For example, the volatility of the median houses price in Melbourne since 1980 is 9.1%. The average capital growth rate over that period was 8.3% p.a. Therefore, two-thirds of the time investors should expect the annual growth rate will range between 0.8% and 17.4%[1].
That compares favourably to share markets which tend to have volatility rates of 18-20%. Therefore, two-thirds of the time share market returns will range between -11% and +28% – a much wider range.
Timing the property market is less important
This chart sets out long-term growth patterns for property in each capital city. It is noteworthy that property tends to eb between two cycles being growth and flat. Of course, it would be great if you could accurately pick when each cycle will begin and end, but you can’t. It is very difficult (read impossible). Markets cycles can last longer than you may expect. For example, Melbourne’s apartment market is a good example of this – it’s been flat since 2010.
Perhaps one relatively reliable indicator could be if historic growth over the past 6-7+ years has been materially above or below the average, that could be a sign that the market cycle will change soon. For example, if the growth over the past 7 years has been say > 13%, then it’s likely the market will soon enter a flat cycle. Apart from that, timing the property market is less important, because the likelihood of a significant fall in value is low (based on historical data), unlike with shares (NASDAQ example above is case in point).
However, non-investment-grade property markets can be more volatile
Some (non-investment grade) property markets can exhibit higher volatility and experience share price declines. For example, beachside markets that are dominated by second homes (i.e. not primary owner-occupier homes) are good examples of this. In these markets, timing becomes more important.
Time will be less important in the long run
Investment timing can have a big impact on your returns in the short run. For example, if you hold an investment for less than a year, then the ‘timing’ when you made the investment can have a big impact on your short-term return. However, the longer your own the investment for, the investment’s fundamentals will be mainly responsible for your long-term returns. In short, normal volatility will have an impact in the short run but very little impact in the long run.
The only exception to this is if you invest before a market crash/correction. For example, if you invested in the Australian market in September 1987, just before the market crash, your investment would have lost about 45% of its value by February 1988 – not a good start. If you held that investment today, you would have generated a return of only 3.4% p.a. (excluding dividends). Holding that investment for almost 35 years still hasn’t made up for the unfortunate timing.
Should you sell if an asset-class is over-valued?
If markets move in cycles, then what you could do is buy when the asset is under-valued, sell it when it becomes over-valued and reinvest those proceeds in another under-valued asset class. Whilst this approach has merit, it is often difficult to identify market cycles in real time with perfect accuracy.
A less aggressive approach would be to reweight your asset allocation every year or so. This involves reducing exposure to asset classes that appear over-valued (i.e. taking profits) and reinvesting these monies in asset classes that are likely to deliver above average returns i.e., under-valued. Maintain a diversified asset allocation means you don’t have to guess which baskets to put your eggs in.
Don’t ignore timing but quality and time are more important
I would like to leave you with three insights:
- Small timing mistakes don’t matter if you optimise your investment quality and hold the investment for the long term.
- You must avoid making big timing mistakes, as its unlikely time will make up for them e.g., invest just prior to a 30%+ crash.
- Timing is less important for residential property, due to its lower volatility rate.
Therefore, the saying should be amended to read; “time in the market is more important than timing the market, as long as you don’t invest before a crash!”.
[1] 95% of annual returns will be between -10% and +26% (being average return -/+ two standard deviations).
