Quant Concepts: What happens when you sell

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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. Throughout the past few weeks as COVID-19 continues to grow its footprint worldwide, we've seen several days of drastic declines in the market. These declines are typically driven by investor panic as declining account balances spur even more seasoned investors to get out of the market. We've talked a lot about why it's important to stay invested over the long term, but some may argue that timing the market can provide additional downside protection in volatile markets. Market timing refers to the practice of selling out of the market before the market declines, or before it declines further than it already has, and then investing back in when it's set to turn around. In theory, this might sound like a simple and even rational strategy, but in reality, successfully timing the market has proven to be extremely difficult, even for the most experienced money managers.

In today's video, I'm going to explore the effects of missing out on the first month of positive performance following the 2008 credit crisis. In other words, investing into the market one month after the market starts to rebound. Given investors at that time wouldn't have known whether the market was just beginning a long term rally or whether this was a one-off, the scenario is a very realistic possibility for those who pulled their money out at some point and were looking for one to reinvest. I'll be comparing the CPMS Canadian dividend growth model invested both with and without that first month of positive performance. So, first off, let's take a look at what month that is.

So, here, what we're looking at is the S&P/TSX, the index return, across 2008 and 2009. So, what we can see here is there's a lot of months in a row that show negative returns. And what we're looking here is the first month where that starts to rebound, and that is in March of 2009. So, the scenario that we're going to run is the Canadian dividend growth model run both with this month included and without. So, in the first scenario, it will run at the beginning of March, and that will include this month. The second scenario, it will run at the end of the month. So, it will miss out on this particular month of returns.

So, the model that we're investing in, just a little bit more about it. We're going to rank the universe of Canadian stocks, which in this case is the CPMS 250, and that's the 250 largest stocks based on market flow. We're going to rank them, some of the factors here, on expected dividend yield. So, that's looking at whether or not a stock has a high dividend yield or not. High dividend yield stocks would be ranked higher than stocks with a lower dividend yield. Expected dividend growth is what they're expected to pay and if they're expected to grow their dividends across the next year. Again, higher values for that are preferred. And five-year normalized dividend growth. So, that looks at an annualized number for their dividends paid across the last five years. And again, we'd be hoping for higher numbers on that.

Some of the screens that we will apply here – for the dividend yield, we want that to be in the top two-thirds of peers which today that has a value of 1.89% yield or higher. The expected dividend growth, we want it to be greater than or equal to zero. So, what that means is, we want a company to be maintaining its dividend or growing it. And then, five-year dividend growth, we want to see that either greater than 2%, or an expected dividend growth greater than or equal to 10%.

On the sell side, one of the sell criteria we're going to look at is expected dividend growth, again, if that falls below zero. So, what that translates to is, if a company were to cut their dividends, we'd sell the stock from the model.

So, once we run both of those back tests, we've got the output here. This is the first model. So, this one is incorporating or encompassing that March 2009 return. So, you can see the back test runs from February 2009 until February 2020. In this scenario, we've invested $100,000 and split that across 10 stocks across that timeframe and applied those buy and sell rules. So, across that we can see this version of the model returned 13.3% with a turnover of 76%. So, that's how much we're trading.

In the second version, and that's the one where we're missing out on the March 2009 returns, the return actually shot down to 12.3%. So, that may look insignificant because that's really only a 1% difference. But what that 1% translates to and accumulates to across that timeframe actually is an 11.4% difference between the two models. So, with $100,000 being invested, this version would have returned you about $352,000. This version here would have actually returned you $393,000. And that's about a $40,000 difference. So, while that 1% might seem not a big deal, and the 30 days that you missed might seem like such a small amount of time, that can compound into quite a bit of loss and $40,000, of course, that could be a new car, that could be the down payment on a house. Or if you're in retirement, that could be a good chunk of your annual retirement spending. So, you could have avoided that had you actually stay invested and not tried to time the market.

So, while it might seem attractive, it might seem like a good scenario or a good strategy to follow, it's very difficult to implement successfully and can have very big consequences even if you get it just slightly wrong. So, all that to say, probably best to stay invested, follow your usual investment plan and don't try to do anything too fancy because it's hard to get it right.

For Morningstar, I'm Emily Halverson-Duncan.