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Forget About ‘Timing the Market': Schwab Research Reveals the Optimal Way to Invest

Can investors realistically time the market to maximize returns, especially over the long term? According to a recent study from Charles Schwab, perfect market timing is impossible. The firm’s research showed that most investors are better off investing as soon as possible using a buy-and-hold strategy rather than trying to predict short-term peaks and valleys.

To produce their new study, researchers at the Schwab Center for Financial Research analyzed the hypothetical 20-year returns of five investing strategies using historical S&P 500 data. Each hypothetical investor received $2,000 every year, which they could invest however they like.

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It’s Too Soon to Say the Value Premium is Dead

The underperformance of U.S. value stocks since the Great Recession has received much attention from the financial media, and prompted at least some investors to conclude that value investing is dead. That has led to papers being written, such as AQR’s May 2020 article, “Is (Systematic) Value Investing Dead?” Because the value premium has been much larger in small stocks than in large, we’ll review the performance of small-value stocks compared with broad market indexes. From 2008 through July 2023, while the S&P 500 returned 9.8% per year, the Fama-French small-value research portfolio returned 8.6%, an underperformance of 1.2 percentage points annually. (Fama-French data is from Ken French’s website.)

A Cautionary Tale

We heard the same argument about the death of the value premium in 2000. From 1994 to 1999, the S&P 500 returned 23.6%, annually outperforming the Fama-French small-value research portfolio by 7.2 percentage points. However, the declaration of the death of the value premium was premature. From 2000 to 2007, while the S&P 500 returned 1.7%, the Fama-French small-value research portfolio returned 16.2%, outperforming by 14.5 percentage points annually. Such performance should be a cautionary tale for those declaring the death of value.

If the underperformance of the value premium in U.S. stocks since 2008 was a sign that value was dead, we should see similar underperformance outside the U.S. From 2008 through July 2023, the MSCI EAFE Index returned 3.2%, but the Dimensional International Small Cap Value Index returned 5.2%, outperforming by 2.0 percentage points annually. In emerging markets, while the MSCI Emerging Markets Index returned 1.7%, the Dimensional Emerging Markets Targeted Value Index returned 4.1%, outperforming by 2.4 percentage points. Thus, outside the U.S., investors who diversified their portfolios to include small-value stocks benefited.

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Taking Tax-Loss Harvesting to the Next Level

 The empirical research has shown that tax-loss harvesting strategies in separately managed accounts can improve the post-tax returns of an investment portfolio by employing a strategy of selling positions in securities with losses in order to generate capital losses that can be used to offset gains generated in the overall portfolio. The Internal Revenue Code permits capital losses to be netted against capital gains in the year they occur. Unused losses can be carried forward indefinitely, deductible against future net capital gains plus an additional $3,000 deductible against ordinary income per year.

Since long-term capital gains are often taxed at lower rates, a tax-loss harvesting strategy can improve a portfolio’s after-tax performance. While long-term losses are generally hard to realize systematically because stock positions on average appreciate over time, in the short term, volatility allows for the capture of short-term losses. The result is that most losses end up being short-term, which can be used to offset highly taxed short-term gains. With that said, most of the benefit from tax-loss harvesting is from the deferral of gains (offsetting realized gains from other assets in the portfolio).

 A key benefit of tax-loss harvesting is that it can allow investors with concentrated positions in low-basis stock to diversify their holdings as tax-loss harvesting losses are realized—the losses are used to offset some, or all, of the taxes due on the sale of the low-basis stock. It can also help offset the capital gains taxes generated by less tax-efficient (higher turnover) equity strategies such as those of active managers.

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