When the market is near all-time highs, and “surely can’t keep going up”, it only seems responsible to move your investments to a “safe” place before the market tanks, right?
Though seemingly a sensible idea, this approach would likely be harmful to a long-term investor.
So much of investing is contrary to what our life experiences have taught us, and market timing is one of those financial evils that must be dispelled.
If you’re a do-it-yourself investor and employ market timing, it’s forgivable because market timing seems like such a common sense idea. Who wouldn’t want to sell their investments when they are at their highest, to lock in the maximum gains, and then buy them back after a market plunge when they are at their lowest? It seems sensible right?
The problem with this strategy is that it requires you to be right twice. You have to know when to get out of the market before the downturn and when to get back into the market before you miss the recovery.
Both of these events are very difficult to predict. How could you know when anything is at its highest price and will not continue to go up, or that it will not go down in price any further?
The answer is, you can’t; nobody can. That’s why anyone who employs market timing as a long-term “strategy” for investing is no more than a prognosticator looking into their crystal ball to tell the future.
One of the biggest issues with market timing is that it inevitably results in money being on the sidelines instead of being fully invested in the stock market. Since the market goes up over time, any money sitting on the sidelines is likely to miss out on returns.
Dimensional Fund Advisors is a research-based mutual fund company that manages half a trillion dollars in assets, and they observed how often the stock market closes positive or negative on a daily, monthly, and yearly basis. The results were fascinating.
On a daily basis, the market closed positively 55% of the time, while it closed negatively 45% of the time. This is essentially a coin flip. If for example you sell your investments today with the hopes of getting back in the market tomorrow, you may only have a 45% chance that it will work out in your favor.
If you look at the monthly data, 63% of the months had a positive return. That means if you are out of the market for a month, you may only have a 37% chance of it working out in your favor.
If you look at the yearly data, 70% of the years ended with a positive market return, while only 30% ended with a negative return.
This indicates that if you want to give yourself the best chance of reaping the long-term positive returns of the stock market, then you have to stay invested over the long-term. The odds clearly suggest that jumping in and out of the market over the long-term has a high likelihood of underperformance.
There is another interesting study from Cambridge Associates that looked at the impact of market timing from the perspective of being out of the market at the wrong time when the market rebounded. The study found that if a person had missed only the five best days out of 72 years of investing, it would have reduced their cumulative compound returns (without dividends reinvested) by nearly 50%! Take a minute to let that sink in. Being out of the market for only five days – albeit five highly important days – can have a monumental negative impact.
Now, this is certainly an extreme scenario, but there is a crucial lesson here. Usually, the biggest market rises follow the biggest market declines. Not coincidentally, market timers often pull their money out after a fall, and wait to get back into the market after it has steadily been rising. This means that for many market timers, they have missed out on the biggest part of the rise, and thus will miss out on much of the returns. Since we can’t predict market highs and lows consistently over time, the only way to ensure you receive the premium returns from your investments is by staying invested – even during the declines.
You would think that financial professionals with a pedigree from prestigious colleges and advanced certifications would be able to create value through active management, and beat their benchmarks. The reality is that more often than not, they fail to do so.
Dimensional Fund Advisors looked at professional active managers and the funds they manage over a period of 5, 10, and 15 years. The results were startling. Not only did many of the funds close due to poor performance, but the vast majority of professional active managers underperformed their benchmark over the long-term!
Over the 5-year period of the study, 82% of the 2,867 funds survived (18% closed), with only 26% of the funds surviving and beating their benchmark. That’s right, only 26% of the funds which were actively managed by professionals beat their benchmark. That means 74% of the funds underperformed their benchmark, and likely why these funds were closed.
If you look at the 10-year period, the results are worse. Of the 3,229 funds at the beginning of the 10-year period, only 58% survived (42% of the funds closed), with only 20% of the funds surviving and beating their benchmark.
Finally, if you look at the 15-year period, the data gets very gloomy for active managers. Of the 2,828 funds at the beginning of the 15-year period, only 51% of the funds survived, and only 14% of the funds survived and beat their benchmark. Thus, these professional active managers - who are supposed to be the best of the best - closed 49% of the funds they managed, and 86% underperformed their benchmark over 15 years. Such an abysmal track record doesn’t bode well for investors.
So if you can’t time the market, and professional money managers can’t time the market over the long-term either, then what are you left to do? The simple answer is to accept that you can’t predict the right time to jump in and out of the market, and take comfort in the fact that no one else can do it either.
You can free yourself from a lot of anguish and second-guessing of when to get in the market or when to get out by simply buying and holding your investments for the rest of your life. As the stock market jumps up and down along its permanent uptrend, the appropriate response for a long-term, passive investor is to do nothing.
That’s right, when the market is plummeting you need to stay invested and not sell your stocks or mutual funds. I promise that you will want to sell your investments to flee to “safety”, but that’s not what a long-term investor needs to do. By getting out of the market, you will almost certainly miss the eventual market rebound.
Investing requires faith, patience, and discipline, and though market timing and other active management schemes appeal to our desire to have our cake and eat it too (i.e. participating in stock returns without having to live through temporary stock declines), more often than not, they cause long-term investors to underperform relative to a simple buy-and-hold strategy.
By following a simple indexing strategy where you buy a large, diversified “basket” of companies, and hold those stocks or bonds for your lifetime, you will increase your likelihood of receiving the returns you’re seeking, and set yourself up for investment success.
Disclaimer: The sample data from Dimensional Fund Advisors’ research includes funds at the beginning of the 5, 10, and 15-year periods ending December 31, 2017. The sample data from Cambridge Associates’ study came from 1928-2000. Past performance is no guarantee of future results. None of the information presented should be construed as personal investment advice. You should seek the advice of your own financial advisor prior to making any financial decisions.