It is tempting to stay out of the stock market during uncertain times. The gain you might miss out on seems small in comparison to the possibly huge loss of a market crash.
Many investors who do not think of themselves as market timers are still inclined to get out of the market from time to time. It seems appealing to get out:
- in anticipation of events such as Y2K
- before a Federal Reserve rate increase
- when there is trouble overseas, or
- when there is trouble in the U.S. economy
The safety of the sidelines is very appealing. Regardless of your rationale, anytime you temporarily deviate from your investment policy, you are engaging in a form of market timing.
Surprisingly, these seemingly safe moves are very dangerous! If you have near-term goals, the answer is not market timing. The answer is a more conservative investment policy that considers your short-term goals as well as your long-term goals. Staying fully invested in a diversified portfolio that is appropriate for your circumstance is the safest and most reliable way to achieve your financial goals.
Systematic and Opportunistic Risks
Risks in investing fall into two categories: systematic and opportunistic.
Common stocks systematically provide higher returns than fixed income investments. Given three years, it is 78% more likely that large U.S. stocks will produce a higher return than one-month Treasury Bills. It is 84% more likely that stocks will beat fixed income over ten years. The longer you own a common stock portfolio, the higher the probability it will produce a higher return than fixed income. This is a systematic risk that has a very high probability of success given enough time.
Common stocks produce dramatically higher returns and incur dramatically larger losses than bonds from year to year. These are opportunistic risks. Admittedly, if you can avoid the low return periods you will have a higher overall return than if you are fully invested all the time. Unfortunately, no one really knows when the low return periods will occur. Any time you attempt to predict a low return period and take money out of the market, the odds are against choosing correctly. And once you are out of the market, how do you choose the correct time to return?
Temporarily taking money out of the market reduces the probability of long term success. By staying fully invested you guarantee that you will enjoy the high return periods and endure the low return periods.
Time is on Your Side
During the 3,541 trading days of 1980-1993, an investor in the S&P 500 would have realized annualized returns of 15.5 percent per year. If, in an attempt to time the market, the investor missed out on just the best 10 days, the annualized return dropped to 11.9 percent. Missing the 40 best days would have dropped the annualized return to 5.5 percent.
Morningstar® did a study of 199 no-load growth mutual funds for the period 1989 to 1994. The average total return for the funds was 12.01 percent. But the individual investors, during that same time period, earned a total return of just 2.02 percent! Why? The average investors held onto their funds for only 21 months. They were either trying to time the market or chase a hot fund. A similar study of stock mutual funds over the period 1984 to 1996 discovered that the average investor’s return was 10 percent less than the average returns for the funds themselves!
Don’t forget about income taxes and transaction fees, which reduce your return. Every time you buy and sell you incur taxes and fees. It follows that market timing increases both since you are selling in anticipation of a downturn, then buying when you decide the time is right to re-enter the market. After accounting for those additional taxes and fees, the probability of success is even more remote. Another reason market timing doesn’t work is because the market moves in a random manner. Analyzing the monthly movement in the market from 1926 to 1995, 59.2 percent of the months were positive and 40.8 percent of the months were negative. When you take into account the market’s natural upward bias, the monthly movement is just as likely to be up as down in the following month.
Of course, when you consider getting out of the market, you do not do so based on these statistics. You do so because you believe that there are market forces at work that make one particular period of time more risky than normal. You believe that this month the probability of a downturn is more likely due to some economic risk factor.
It is certainly true that over short periods of time some investors have successfully timed the market. Winston Churchill said: “The greatest lesson in life is to know that even fools are right sometimes.” Or, as we like to say: “Even a broken clock is right two times a day.” We hear mostly about the “experts” accurate forecasts and rarely about the inaccurate ones. Predicting in advance which “expert” is right is virtually impossible.
Two research firms studied the asset allocation advice of strategists at the nation’s largest brokerage houses. Their report concluded:
“A decade of results throws cold water on the notion that strategists exhibit any special ability to time the markets. The average annual gain from their decisions was a mere .18 percent.”
The Wall Street Journal, January 30, 1997.
This figure ignored transaction costs and taxes. Once these costs were added, the value of their advice would clearly have been negative.
Market timing adds uncertainty, reduces efficiency, and increases taxes and costs. Thus, it reduces the probability of achieving long-term goals. Systematically adhering to an investment policy uses the opportunities inherent in appropriate asset classes to maximize the probability that you will achieve your goals.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Indices are not available for direct investment; therefore their performance does not reflect the expenses associated with the management of an actual portfolio. The index returns above assume reinvestment of all distributions. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.