The Dangers of Timing the Market

Today's sharp move higher in the stock market sheds light on the dangers of an investor trying to time the market. I wrote a post earlier this year, Focus on the the Long-Term, in which it was noted missing just a handful of the market's best days in a given year can really penalize returns. If an investor missed just 40 of the biggest up days in the market over the last 20 years (1987-2007), their return would have totaled 3.98% versus remaining fully invested and achieving an average annualized return of 11.82%.

The market research firm DALBAR went one step further and looked at the returns of mutual fund investors over the 20-year period, 1986-2006, and reported the average market timer return was -2%. During this same time period, the S&P 500 Index returned 12%.
 

• Additionally, during the 10-year period 1997-2006, the S&P 500 Index achieved an annualized return of 8.4%. If an investor missed just the top 20 days during this period, their return fell to -.4%.

• Further, 21 of the best 40 days came during the bear market period 2000-2002.

• Lastly, nearly three-fourths of the 40 best days came within two weeks following a worst market day.

A key investment decision for an investor should be to review their overall asset allocation. If the review, and investor risk tolerance, indicates additional equity exposure is appropriate, then maybe now is a good time to begin averaging into the market.

Source:
Market Timing Doesn't Work
Charles Schwab OnInvesting
By: Liz Ann Sonders
Fall 2007

Volatility and Complacency Make Strange Bedfellows
Charles Schwab OnInvesting
By: Liz Ann Sonders
Summer 2007

Comments

[punk_ash:]

Run your calculation again and see what happens if the same portfolio misses the 40 biggest losses and I bet you will surprise yourself and the return will be better than the market return. Back up your story with some facts and just some mumbo jumbo. and you are welcome...

2008 Oct 14 03:24 AM

[David I. Te...:]

punk_ash....The issue is I do not know any famous market timers. The difficulty with market timing is one needs to get two decisions right, 1) get out of the market and 2) get back in. Generally, the emotional and psychological aspects of investing prevent one from getting both decisions correct. The above facts do show that market timers are unable to get in on the day before the big up move in the market. In the end, it is time in the market and not timing the market that matters most.

2008 Oct 14 06:54 AM

[balsamo001:]

One of the most misleading study you ca

2008 Oct 14 08:31 AM

[balsamo001:]

Sorry...One of the most misleading you can find....It supposes that any individuals lives 100 years...what about the lost generations ? The ones that started investing in 1929, 1965, 2000 or more recently 2007 ? Only their children or grand children would have get any return.

Those kind of bullshits are the main reason why retail investors never sell or buy when they should. It should be banned.

2008 Oct 14 08:37 AM

[Shinjimas:]

punk and balsam:
Who gets an inheritance and invests the entire amount the day before the market crashes? Almost no one. We all invest over time and over time, the market returns a good average. What about "the ones that started investing in 1929, 1965, 2000 or more recently 2007?" They are now buying shares on the cheap that will reward them over time. The more we try to time the market, the more we leave our returns to chance.

2008 Oct 14 09:21 AM

[y3115y:]

Most hedge funds are timing in and out, as well as day traders. It is hard to time, but the reward is good.

2008 Oct 14 09:27 AM

[xpatUSA:]

Simplistic statements and study presentation graphs can never tell the full story, IMHO. There are many investing styles and within those style there are those prosper and those who fail.

At 68 years old and being a diabetic, I don't have the luxury of putting my money for 20 years anywhere! Therefore, I am a very frequent trader, consciously timing individual investments, both stocks and commodities.

All I want is to beat about 1.5 % a month i.e. price inflation and taxes. Might even get there this week if stocks rise enough.

T.C.

2008 Oct 14 09:28 AM

[CLH:]

Yes I agree with you market timing is a loser.

2008 Oct 14 10:09 AM

[irondoor91:]

Most general equity mutual funds (approx 85%) cannot beat the market even when they are supposed to be more or less fully invested.

Statistically, half of the top quartile funds in one year or five year period will fall into the bottom quartile over the next measurement period. And, of course, the inverse is true that half of the bottom quartile funds will end up in the top half over the future period. Investors tend to be in active funds rather than the index funds, since those are the ones that their advisors recommend, they are always chasing the top performers, which are naturally going to be underperformers in the future.

Active mutual funds investors' returns are approximately half the market returns because of this chasing plus the layers of fees inbedded in the funds and the overlay of advisory fees.

2008 Oct 14 10:10 AM

[Indexor:]

David, I simply grin when these same old stale statistics, created by the mutual fund industry, who only earn fees as long as investors REMAIN FULLY INVESTED in their funds (no conflict of interest there), show that "It's time IN the market, not timing the market."

Or DALBAR (who make their living consulting to the mutual fund industry) updates their "If you only miss the 40 best days" argument. Punk_Ash already gave you a perfect answer. Why look at only HALF the equation? Instead of only missing the 40 BIGGEST UP days, also add to that missing the 40 BIGGEST DOWN days as well. The numbers will surprise you.

Both DALBAR and the mutual fund industry have misled the general investing public on this topic for a very long time. Even after yesterdays largest ever one-day gain of 936-points, wouldn't you (and your clients) be better off if you had sold your mutual funds in early January, as the market began selling off? Yes you both would be SUBSTANTIALLY better off.

I suggest you look up the name Mebane Faber. Find an article he published here within the last six months in which he provides a link to a study he conducted that was titled: "A Quatitative Approach to Tactical Asset Allocation." Using a very similar methodolgy, our real world experience allowed us to sidestep the carnage beginning in October of 2000 and got us back in during March of 2003. Again, we exited early in January of 2008 and remain on the sidelines until the markets tell us to return.

Please take a another step forward and get beyond the boiler plate mutual fund "educational research" that is so widely available. Think for YOURSELF and do your OWN research and you may find there really are better and safer returns available to you and your clients than from the "Buy-and-Hold" methodology that only guarantees profits to the mutual fund, in good markets AND bad. As Mebane stated in his article, it is possible to achieve "equity-like returns with bond-like volatility and drawdown" which is what most mutual fund/ETF investors strive to achieve.

2008 Oct 14 10:49 AM

[balsamo001:]

What i meant is that there are simplistic ways to time the market. When the PE are high and if your in, be prepared to sell...if the PE are low, and you're not in the market, then be prepared to buy...there are cycle long term...if you get in the market at the wrong time, it could take years to recover...So no, the one who bought the SP500 in 1966 lost money all his live and eventually his son or grandson broke even in 1984 (or 1991 if included inflation)...

All those buy a

2008 Oct 14 11:44 AM

[balsamo001:]

re sorry

All those buy and holds theories are pure non sense...As far as i concerned when in the morning i see dark clouds on the horizon i will put a rain coat on...Well i saw black clouds back in 2006, and sold in April 2007...
If if would have stayed in the same 2006 positions, i would be down 38% since then... i am actually up 15% YTD...

And what if you would have buy and hold in AIG, BS, WAMU, and all the casualties of this bear market...Buy and hold is like hiding your head in the sand... IMHO, Buy anbd holders shouldn't be investing at all

2008 Oct 14 11:49 AM

[Chuck LeBeau:]

Buy and Hold is bad advice nowadays and has been for many years. The markets are much too volatile and even quality stocks are subject to large declines. A drawdown study of the S&P 500 stocks conducted by SmartStops.net shows that from January 1998 up to October 10, 2008

There were 61 stocks that had experienced a drawdown of greater than 90%

There were 124 stocks that had experienced a drawdown of greater than 80%

There were 204 stocks that had experienced a drawdown of greater than 70%

There were 305 stocks that had experienced a drawdown of greater than 60%

There were 383 stocks that had experienced a drawdown of greater than 50%

There were 447 stocks that had experienced a drawdown of greater than 40%

The actual result might be even worse because this study is subject to the positive effects of “Survivorship bias” because in this ten-year period there have been a number of stocks that went out of business and were deleted from the Index. These stocks had declines of 100% but are not included in this study.

Buy and Hold ignores any concept of risk vs reward. In today's markets the rewards of Buy and Hold are meager or even negative and as you can see from the quoted study, the risks are very great. In order to have a better reward with less risk market timers do not need to pick tops and bottoms. They just need to generally respect the major trends and limit losses.

A study published by Smart Trade Pro of the S&P 500 from 1984 through 1998 shows that it is much more important to skip the worst days in the market than to enjoy the best days. If you skip both the best and the worst days you will come out way ahead.

Remember that recovery from one of those 50% declines requires a 100% gain just to get back to even. Avoiding big losses is the key to success these days and you sleep much better in the process. Buy and Hold has unlimited risk and keeps you in the market all the time. That might be an acceptable level of risk if the rewards were high enough but my studies at SmartStops.net show that some simple market timing produces higher returns with less risk.

2008 Oct 14 05:15 PM

[User 279557:]

Your sources are dubious at best. Any article that mentions dollar cost averaging as a legitimate investing methodology is incredibily naive at best and should be considered malpractice.

Sources:
- George M. Constantinides. “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.” Journal of Financial and Quantitative Analysis. XIV, June 1979, pp. 443–50.

- Kirt C. Butler and Dale L. Domian. “Risk, Diversification, and the Investment Horizon.” Journal of Portfolio Management. Spring 1991, pp. 41–47.

- Richard E. Williams and Peter W. Bacon. “Lump Sum Beats Dollar-Cost Averaging.” Journal of Financial Planning. Volume 6, Number 2, April 1993, pp. ?

- John Greenhut. "Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work"

2008 Oct 14 07:25 PM

[rmiggie:]

I agree wholeheartedly with Indexor, Chuck LeBeau, & User 279557, and thank you for the references you provided.

What kind of investor would be out of the market only for the 40 best days over a 20 year period, and in the market for every other day...including being in the market for the 40 worst days over that 20 year period, as Indexor mentioned? That would require the investor to have made the 80 worst possible trades over that 20 year period, and never have made any other trades. He would have had to sell the day before and buy the day after each and every one of the 40 best days, and remained in the market for the entire time between best days, each and every time. How absurd, how deceitful and how manipulative is Mr. Templeton's (and Mr. Schwab's) argument?! It's outrageous.

2008 Oct 15 12:44 AM

[Jim Hawthorne:]

This article is pure rubbish. At the end of WW II, we were the last economy standing, and have been the dominant economy ever since. Yes, the good times surely rolled. We are now in the process of a seismic global financial, economic and market shift, and the assumptions that any US stock we somehow consider "good" will automatically rise over time, and that we will continue to profitably grow at past rates are questionable.

In addition, there is a HUGE distinction between "market timing" (attempting to anticipate or predict major market movements) and "trend following" (recognizing major uptrends and downtrends and acting accordingly).

While PREDICTING market moves in advance is very tough, spotting TRENDS is not!

The author uses mutual funds as a benchmark. There is not one, NOT ONE mutual fund manager who does not engage in trend following!

The most successful traders do likewise!

2008 Oct 15 08:41 AM

[daytrader:]

INDEXOR IS 100% RIGHT.

it's a scam by mutual funds or dividend reinvestment programs.i lost so much money with the buy&hold strategy;yeah.hold this,you wouldn't believe it.then i read a very interesting article by justin kueppner on day trading as well as some other literature.here is the philosophy,which for me has been working quite well.mind you,i have only been seriously trading for eight months,but remember this.what took me almost 27 years to loose with bs brokers,cramer,mutual funds&drip's,plus the bs on cnbc,etc.etc.etc.,i have made back over half of what i lost!hard to believe?it's the truth.

the rules.

1 follow the rules you set up
2 don't be greedy
3 you make more money by being out of the market than by being in
4 only listen to yourself.you have a brain,use it
5 plan the trade&trade the plan
6 "success is impossible without discipline"
7 do not run or chase after a stock.let the stock come to you.buy the stock at your price,not thiers.
8 most importantly,PATIENCE!w... the rush?STAY CALM

2008 Oct 16 10:22 AM