We are once again on the knife edge. With the debt crisis in Europe and the fiscal cliff in the US, we could muddle through (most likely), but the combination of effects could create another bear market. As a result, we think it is a good idea to visit the question of tactical allocation versus buy-and-hold (no matter what) -- and specifically the popular claim that tactical allocation misses the top X days with calamitous impact on total return.
US corporations are in good shape, US banks are better capitalized than in 2007, and charts are still trending up (the action last week took us back out of correction territory for the moment). BUT the potential break-up of the EuroZone is a gigantic uncertainty factor for markets, the fiscal cliff could create recession in the US, and China is slowing -- and then we have the Syria civil war and the Iran nuclear program, each of which could have large market impacts. External events are the big deal right now -- we simply have to watch and wait.
This weekly, multi-year chart shows the S&P 500 still trending up, but with correction moves in 2010, 2011 and 2012, each based on Europe worries. If Europe went from worries to a real fracture, would the charts go from correction to bear? Add the fiscal cliff in January 2013 which is presumed to take 4% away from US GDP in a 2% growth environment, and a bear is not an unreasonable possibility. We think things will work out, but what if they don't?
Chart shows 40-week moving average (tan line) and 20% bear market threshold (red line).
That brings us back to the question, is it better to be fully invested at all times and endure, or is it better to be tactical about major market cycles. Being tactical means that some or many of the single best days may be missed. Is the near religious conviction with which many say missing the best X days is a major mistake misleading? We think so.
Let's try to fact check by a literature review.
One of the most ubiquitous investment mantras is "Don't Miss the X Best Days in the Market". The proponents of that view present data showing the returns from missing those best days being substantially lower than a "buy-and-hold" approach -- that "time in the market, not market timing" is the essence of successful investing.
While there is a lot of good to say for a long-term perspective and avoiding emotion and headlines driven jumping-in and jumping-out, and against day-trading, the "Don't Miss ..." argument is incomplete and misleading, because it only tells half of the story. It fails on both a logical and data basis to be as ironclad as it is presented.
That mantra has become one of the unquestioned "facts" in investment lore, that is repeated over and over in market literature, but without disclosure of countervailing arguments and data.
The insinuation, if not outright statement in some cases, is that all tactical approachs of being in sometimes and out sometimes is the same thing as attempting pinpoint identification of perfect tops and perfect bottoms, or frequent in and out behavior. We believe that investors who move away from bear markets and toward rising markets over market cycles are not doing the same thing that "market timing" implies.
Regardless of your beliefs on this touchy subject, we think you will find the information that follows from a variety of sources with different views interesting (or infuriating, depending on your temperament).
PROPONENTS OF "DON'T MISS"
Goldman argues in "Penalty for Missing the Market" that staying in the stock market (the S&P 500) in up and down cycles works best. Their image below shows that if you miss the 70 best days out of 5047 days (about 1.5% of days) your return goes from 7.81% with a 20 year buy-and-hold from 1992-2011, to -7.20%.
As an aside, we find the Goldman position a bit humorous given their proprietary approach to trading and market timing as a core business. That contradiction aside, their statement is consistent with many asset managers.
In "Watching From the Sidelines May Cost You" Franklin looked at the same 20 years. While Goldman analyzed missing 10, 40 and 70 days, Franklin Templeton measured missing 10, 20, 30 and 40 days with the same kind of result.
GE Asset Management
"Stock Market Ups and Downs" by GE Asset Management took the same tack. They analyzed the S&P 500 for 31 years through 2011, and looked at missing best months instead of best days -- probably a more realistic set of time frames for most investors. Traders may have daily in and out, but we suspect that most investors who enter and exit over a period of a few decades would be in or out for months at a time.
The results show a similar diminution of return by missing the best periods, but in the case of months the result is not negative, as it is with missing days.
"In fact, while we cannot say that this will continue to be true in the future, long-term investors who remain invested through the ups and downs of the market have generally gained the advantage over investors who try to be invested only at the right time."
"By staying fully invested [with a $10,000 intitial investment] over the past 15 years of the S&P 500, you would have earned $12,779 more than someone who missed the market's 10 best days."
Their data looks at missing the 10, 20, 30 and 40 best days of the 25 years of 1997 through 2011.
In "Missed Opportunity Can Be Costly" BlackRock looked at 20 years from 1992 through 2011 if you missed the best 5, 10, 15, 20 and 25 days in the S&P 500.
Buy-and-hold with an initial $100,000 generated about 4 times the ending value as missing the top 25 days. Missing top days barely made a gain over 20 years.
The argument is in many countries, perhaps all of them.
Here is what Fidelity India showed. Their chart in "Timing the Market" shows that after the 2008 crash missing the best days made a huge difference in return from that point.
Their "Miss a Little, Miss a Lot" brochure said,
"To have and to hold for better or for worse…Unsuccessful market timing can lead to a significant opportunity loss. A buy-and-hold strategy may prove more successful in keeping portfolios well positioned regardless of what direction the market takes."
Standard & Poor's
"The Effect of Staying Invested vs. Missing TopPerformance Days for Domestic Stocks, 1997 to 2006" by Standard and Poor's showed how missing the best 5, 10, 15, 20, 25 or 39 days of the S&P 500 was deleterious.
"Missing the market's top-performing days can prove costly. This chart shows how a $10,000 investment would have been affected by missing the market's top-performing days over the 10-year period from December 31, 1996, to December 31, 2006. For example, an individual who remained invested for the entire time period would have accumulated $22,451, while an investor who missed just ten of the top-performing days during that period would have accumulated only $13,996"
COUNTER ARGUMENTS TO "DON'T MISS"
Journal of Financial Planning (Paul Gire)
In "Missing the Ten Best" Gire expresses concerns about the one sided presentation of data on missing best days without also exploring missing the worst days, and missing both the best and worst days.
"For years Wall Street and the mutual fund industry have advanced the concept that investors should buy and hold. A common piece of evidence to support this recommendation is various versions of "Don't Miss the Ten Best," which show that missing just a small percentage of the market's best days dramatically reduces investor returns. … This assertion has been repeated so often in various forms that it's become unquestioned. Like the air we breathe, this orthodoxy is unconsciously accepted and taken for granted. Think about it. Have you ever read an article that critically examines this claim? … Not only does missing both [best and worst] result in superior returns - imagine the knock-off benefits from lower volatility, especially on client psychology. As many advisors have learned since the 2000-02 bear market, it's one thing to encourage clients to stay the course when markets are trending steadily higher, quite another when bear markets rapidly erode the gains from years of careful saving and investing. In 30 months the 2000-02 bear market erased half of the market gains of the previous 26 years-since 1974."
The article presented these data showing the effect of missing the 10, 20, 30 or 40 best days in the S&P 500 from 1984 through 1998, as well as for missing the worst days during that time, and also the effect of missing both the best and the worst days during that time.
The data show that missing the worst days is more beneficial than capturing the best days, and that missing both is helpful. We would add that missing both would reduce volatility as well.
In "Rethinking Risk" Invesco introduced the topic with:
"It was the best of times, it was the worst of times … Charles Dickens wasn't thinking of the stock market when he wrote his famous line, but that message can serve as a good reminder for investors: There are two sides to every story. … The problem with focusing on only half the story is that it emphasizes the effects of the best days while ignoring the worst."
They put their statistics in text form as follows:
"Over 81 years S&P 500 (and precursors) "Returns decreased by approximately two-thirds if you missed the best performance days. Returns more than tripled if you missed the worst performance days. Returns increased overall and volatility decreased if you missed the best and worst days. … The best and worst performance days have historically often occurred in proximity [volatility clustering]. It is virtually impossible for investors to successfully predict market movement to capture positive performance and avoid negative performance. … all of the  worst performing days hit during bear markets. But so did 7 of the 10 best performance days [QVM note: referred to by others as 'volatility clustering']."
So their point is that because the best and worst days tend to occur within bear markets (and as other sources will show) best and worst days tend to occur close together, it is difficult to have or miss one without the other, and nearly impossible to capture the best without enduring the full effect of bear markets.
They go on to explain why missing the worst days is important, because it takes more gain to make up for a loss than loss to wipe out a gain. Then they conclude with what is our philosophy, which is that buy-and-hold, come Hell or High Water is too far in one extreme, while trading with attempts to call tops and bottoms is too far in the other -- implying that missing the bulk of a bear and catching the bulk of a bull is most effective.
"As a portfolio loses value, the needed break-even returns grow substantially. … We know that at the end of 81 years, all the market's up and downs would result in a return of $5.18 for $1 investored in January 1928. But who has 81 years to invest? … The numbers show that relying on pinpoint trades isn't the most effective strategy -- but depending on your time horizon, a buy-and-hold strategy may not work either … "
They also make a point we have made many times - what makes sense for a young person or a mid-career person, is not the same as what makes sense for someone who has completed their accumulation stage of life and is at or near retirement, and needing to relying on their portfolio for sustenance.
"Depending on your time horizon, it may be impossible to recover from the losses of a bear market. ... Your first investment priority should be to minimize risk, not maximize returns."
In their 2011 article, "'Best Days' Argument: Factor or Fiction?" they examined the net flat period for the S&P 500 from 2000 through most of 2011 and argued that only talking about best days is misleading.
A look at the most recent nearly 12 years of data (1/1/2000 - 11/30/2011), however, reveals significant flaws in the 'Best Days'
- The 100 best days are completely offset by the 100 worst days (+376.4% for the best days, -376.0% for the worst days). 'Best Days' and 'Worst Days' occur at about the same frequency and at about the same size - they are the mirror image of one another, at opposite ends of the distribution curve of daily returns.
- You can't be in the Market in order to get the benefit of the 100 Best Days without being in the Market and getting the damage from the 100 Worst Days...thereby netting you nothing.
- It is well documented that Bear Markets are characterized by substantially higher volatility than Bull Markets. Therefore, one might expect that more of the 'best' and 'worst' days would occur in Bear Markets than in Bull Markets. But the degree of lopsided-ness is shocking
Best 100 Days (1/1/2000 - 11/30/2011):
- 10 of the top 10 occurred in Bear Markets (100%)
- 21 of the top 25 occurred in Bear Markets (84%)
- 46 of the top 50 occurred in Bear Markets (92%)
- 73 of the top 100 occurred in Bear Markets (73%)
Worst 100 Days (1/1/2000 - 11/30/2011):
- 8 of the top 10 occurred in Bear Markets (80%)
- 20 of the top 25 occurred in Bear Markets (80%)
- 39 of the top 50 occurred in Bear Markets (78%)
- 70 of the top 100 occurred in Bear Markets (70%)
So, the best and worst days are not only more likely to occur during Bear Markets than during Bull Markets, but overwhelmingly more likely!
The article provides a very nice two page listing of the dates and size of the best and worst days (along with whether they occurred during a Bull or a Bear market). It clearly shows that best days are heavily concentrated in bear markets, and therefor capturing the best days requires enduring the bear markets. If the major bear markets can be avoided (which we contend is different than the meaning of the term market timing) than the worst days will be mostly avoided, and the best day will be mostly missed, and the results will be similar to buy-and-hold, but with less volatility, which would be important for emotional and financial reasons for retirees who must sell some assets periodically to live.
Here is a sample of the data we just mentioned:
Stocks and Commodities Magazine
In his April 2008 article, "Missing the Ten Best Days", Richard Ahrens demonstrated that best days and worst days are clustered so tightly together that you can't have one without the other (in anything but a brilliant and hyperactive trading mode). He looked at the best 20 days over 50 years and their proximity to worst days.
The article is definitely worth a read. We'll quote one data paragraph and the conclusion here. The article is quite persuasive.
Sample of his data:
The largest one-day gain in the last 50 years was a huge 9.1% leap. The day before that was remarkable, too. It was the 4th largest one-day move, causing the market to jump 5.3%. In just two days the market blazed upward over 14%. Those two days were Tuesday and Wednesday, the 20th and 21st of October, 1987. But in order to be in the market to capture that windfall, then the odds were very high that you were also in the market on October 19th, when the market dropped more than 20% in one day.
Assuming you bought the SPX in 1955 and held it until today, missing the 10, 15, or 20 best market days in that 50 years would have decreased your final return dramatically. But every one of the 20 best days were accompanied by declines that were greater than the advances on those good days. Every one of them! There were no exceptions. And those declines were so closely tied to the "best" days that there is no known way to capture the gains without also incurring the adjoining losses. Since the adjoining losses were consistently larger than the wins, you would have been better off if you could have avoided the losses, even if it meant missing those outstanding one-day jumps. The best days in the market are nothing more than interesting statistical anomalies. The argument that missing the best days would reduce the final return of a buy-and-hold investment is true, but it also provides no information regarding the question of whether or not one can time the market. A simple moving average cross-over system will cause you to miss nearly every one of the best days and you should be happy to watch them pass by, because you'll also be missing the more-than-offsetting declines those "best" days are invariably tied to.
In this 2009 article by Theodore Wong, "What the 'Missing Out' Argument Misses", Wong examines data from 1871 - April 2009 (using Robert Shiller/Yale data on the S&P 500 and its precursors); and also data from 1942 - April 2009. [April 2009 is just after the bottom of the crash that began in 2008.
This histogram shows how missing the best or worst months (ranging from 1 month to 24 months) impacts owning the S&P 500 versus a buy and hold. Missing the worst has a greater positive impact than the negative impact of missing the best.
This histogram shows how missing the best or worst days (ranging from 10 to 50) impacts owning the S&P 500 versus a buy and hold. Missing the worst has a greater positive impact than the negative impact of missing the best.
This histogram shows how missing both the best and worst months (ranging from 1 month to 24 months) impacts owning the S&P 500 versus a buy and hold. There is some difference between buy and hold and missing both best and worst with the benefits not favoring buy-and hold forever [logically, there would be less volatility if the best and worst were both missed].
This histogram shows how missing both the best and worst days (ranging from 10 to 50) impacts owning the S&P 500 versus a buy and hold. There is some difference between buy and hold and missing both best and worst with the benefits not favoring buy-and hold forever
"Market timing is discredited by passive investment advisors as a voodoo ritual. Buy-and-hold proponents argue most compellingly by citing the "missing out" scenario - they show a dramatic drop in return, to Treasury Bill levels, if investors are out of the markets for only a few good days. Missing these market surges is considered a risk of lost opportunity.
However, they conveniently ignore the risk of being hit by devastating market crashes and the associated emotional stress of staying in the market at all times."
Schroder Investment Management
In Schroder Talking Point, "Deconstructing the 'Time in the Market' Mantra", Greg Cooper, CEO of Schroders Austrailia said,
The catch-cry most commonly rolled out to investors in times of significant market (downward) volatility is 'It's time in the market, not market timing' that is important. While a nice marketing phrase, unfortunately it isn't always true…. What's wrong with the 'time in the market' adage?
Take the common presentation of this statement, which is usually along the lines of "if you had missed the top 10 days of market performance over the long term you'd be xx% worse off".
That statement is indeed in itself correct … However, the logic of the above analysis is flawed. … Most of the key dates above fell in periods when overall market returns were quite poor. … by reconstructing our "missed days" analysis above and assuming that not only did we miss the 10 days in the market over the period but lets assume we missed the 100 prior days and the 100 days thereafter (i.e. Got out early and didn't invest until well after the event).
(click to enlarge)… All of a sudden the notion that it's "time in the market" starts to take on a different twist. Now, by missing the 7 or so months around each of these significant market "upticks" our returns have improved significantly
… 'Time in the market' used to be the rationale why investors should hang on to equities come hell or high water. However this mantra rings hollow to many investors who have seen the value of their equity portfolios halved over the last year. While investing is still about taking a long term view what's more important is the identification of the risks and possible rewards associated with the investments at any one time.
We don't practice market timing, and don't believe it is in the best interest of most people to try. However, we also do not believe that "buy-and-hold no matter what for everybody" is the right thing either. We think tactical allocation (which involves increasing and decreasing allocation to stock and bonds with major market cycles) is appropriate and feasible -- and should not be lumped in with "trading"
Unfortunately, there are those in the buy-and-hold camp who paint all other approaches as "market timing", which takes on a pejorative tone when used.
Let us merely say that if day trading and making a few tactical adjustments at intervals of months or years are the same thing, then we need some new terminology to facilitate a better debate and put activity other than buy-and-hold on some kind of graduated scale.
Someone with a history of exiting and entering stock at intervals of years, can hardly be compared to someone who trades in and out multiple times per day trying to scalp a few pennies per trade.
And, you know what -- many buy-and-hold investors are really buy-and-hold until the pain is too great; then sell at the bottom and be too afraid to get back in until most of the recovery has taken place - unable to recover their losses incurred at the time of capitulation.
Here are two articles, one essentially supporting market timing, and the other not.
In the 2005 article by Richard Buck "Market Timing the Rest Of the Story", Buck presents the impact of the best 5 days and worst 5 days on discreet calendar years one-by-one.
"Critics of timing like to say that if timing took you out of the market during only the very best days or the very best months of some longer period, your performance would suffer enormously. And of course they are right.
This fall, Barrons magazine published a graph showing the hypothetical results of investing in the Standard & Poor's 500 Index in February 1966 through late October 2001. During that period of almost 36 years, an investment of $1,000 in the index would have grown on a buy-and-hold basis to $11,710.
Then, citing a study done by Birinyi Associates ... the article reported that if an investor missed just the five best days every calendar year, that $1,000 investment would have shrunk to $150.
... What would happen, Birinyi asked, if a timing system could be invested in all but the very worst days each year? He found that a $1,000 investment in the S&P 500 Index that missed only the five worst days each calendar year would have grown to $987,120.
... Nobody, of course, has been able to devise any system that could weed out the very worst days of every calendar year.
But market timing usually gets investors onto the sidelines during more bad days than good days. And by doing so, it inevitably reduces the risk of being in the market. As we saw in the bear market of 2000-2001 and again in late 2007 and throughout 2008, that can be worth a lot"
Javier Estrada, PhD Economics
(Nov. 2007) ISESE Business School, Barcelona Spain
In his "Black Swans and Market Timing: How Not To Generate Alpha" Estrada points out that best and worst days cluster together, making them hard to separate, capturing one and avoiding the other -- and he points out that they tend to be more than 3 standard deviation events that are so unlikely that they are virtually unpredictable.
The Abstract for his paper says:
"Do investors obtain their long term returns smoothly and steadily over time, or is their long term performance largely determined by the return of just a few outliers? How likely are investors to successfully predict the best days to be in and out of the market? The evidence from 15 international equity markets and over 160,000 daily returns indicates that a few outliers have a massive impact on long term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent less than 0.1% of the days considered in the average market, the odds against successful market timing are staggering."
Here is some of the data from his study of the primary markets in 15 countries from 1990 to 2006. You can see the average standard deviations of the best 10 and 20 days at 4-5; and the average for the best and worst 100 days at nearly 3 standard deviations.
That's what they say. It's your money. You decide.
Disclosure: QVM has positions in SPY as of the creation date of this article (June 8, 2012).
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