Monday, March 31, 2008

The Effect of Taxes on Market Timing

In a recent post, I described a market timing experiment where a market timer decides each month whether to own the S&P 500 or to hold all cash. The result was that the market timer had to guess right 60% of the time from December 1990 to March 2008 to keep pace with an investor who simply bought and held through the whole time period.

That experiment assumed that the investor was using a tax-sheltered account, as the Canadian Capitalist observed in his comment on that post. What happens if you have to pay taxes on the interest, dividends, and capital gains? I ran the experiment again, this time taking into account taxes. To give the market timer as much help as possible, I assumed that the buy-and-hold investor sells everything at the end of the complete time period and pays capital gains taxes.

Tax rates vary from one jurisdiction to the next. For this experiment, I assumed a tax rate of 40% on interest income and 20% on dividends and capital gains.

I assume that the market timer has some fixed probability of making the right choice each month. Once again, I calculated the market timer’s compound yearly return for various probabilities of making the better choice. Here are the results:

Comparing these results to the tax-free results from the earlier post, we see that taxes hurt the market timer more than the buy and hold investor. Now the market timer has to be right 63% of the time (up from 60% in the tax-free case) to break even with the buy and hold investor.

It may not seem difficult to be right 63% of the time, but every time you choose to jump in or out of stocks, you’ll need to trade with someone who gets it wrong 63% of the time. The truth is that most of the time owning stocks is the right thing to do, and selling is the wrong thing to do. This makes it very difficult to guess the right time to be out of the market with high probability.

If you are investing in an account that isn’t tax sheltered, you have even more reason to avoid market timing.

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