Wednesday, July 8, 2009

Perfect Market Timing: A Thought Experiment - Alpha

Question: What would your returns be if you could perfectly time the market?

Set up: Buy t-bills (USGG3M) or the market (SPX), whichever will have a higher return (assuming perfect knowledge/foresight), at the beginning of the month and sell at the end of the month.

Time Period and Initial Condition
: From January 1954 through May 2009 (~55 years), $1000 pool of capital. The experiment's control is to buy and hold the SPX, with no annual tax consequences and no transaction costs.

Results (CAGR):
No taxes and transactions costs: $1.22 billion (28.8%)

35% annual tax rate but no transactions costs: $22.97 million (19.9%)

Buy-and-hold SPX (control): $35,243 (6.6%)

But as Charlie Munger said, "Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things."
Perfect market timing is impossible.

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