Stock Time

Market Timing: More Evidence Why It Doesn't Work

Stock Time

By its very nature, investing in stocks — both in the U.S. and internationally — courts a certain amount of portfolio volatility. Trying to make buy or sell decisions based on short-term fluctuations, however, can create an extremely uncomfortable investment experience over time. 

For example, consider what happened after a coronavirus pandemic gripped financial markets beginning in early 2020. Major financial publications across the country warned well into the following year of severe repercussions for investors. In such a Jekyll and Hyde period, stock prices dropped. The next moment, values went up. The one constant: markets twisted and turned, churning at a seemingly dizzying pace. 

Unfortunately, it's a pattern we've seen before. As shown below, epidemics and related health scares have disrupted markets, from Ebola and Swine Flu to the SARS outbreak.  

Behavioral finance experts have related making investment decisions during such periods of heightened volatility to driving while feeling the symptoms of vertigo. Timing markets based on the latest natural disaster, geo-political scare or epidemic too often spurs investors to shoot from the hip, so to speak. Reacting in the moment poses a real and present danger — getting sucked up in the latest market head fake and missing out on any subsequent rebound. 

No matter what type of crisis strikes, red flags abound in trying to time stock and bond trades. The table below shows how markets reacted, as represented by the IFA SP 500 index of blue chip U.S. stocks, after several broad market downturns. Notice how undisciplined investors who responded by selling, in effect, would've wound up whipsawing their portfolios and diluting longer-term gains.  

A growing sense of buyer's remorse by traders shouldn't come as a surprise. A host of academic and industry research points to a really bad tendency by active investors: they panic and bail out at just the wrong times. Indeed, data compiled by Dalbar Inc. finds that stock fund investors keep losing big money through ill-timed trading activities.

In its research report "Quantitative Analysis of Investor Behavior," the independent research firm found a typical U.S. mutual fund investor over the past 20 years had realized an average annual return of 5.96% (through 2020).1

That was significantly less than the domestic blue chip IFA SP 500 Index's 7.43% gain per year. It was also quite a bit less than the all-equity and globally diversified IFA Index Portfolio's 8.29% average annual return during such an extended period. (See graph below.)  

"Our research consistently shows that the average investor has displayed a strong tendency to sell at just the wrong time whenever there's a lot of sudden market volatility," Dalbar's president, Louis Harvey, tells us.2

At IFA, we call them "Time Pickers." In the most recent edition of his book on investing, Mark Hebner and his staff at IFA put together tables breaking down opportunity costs related to distinct market-timing objectives. (See Step 4 of "Index Funds: The 12-Step Program for Active Investors.")

As he points out, avoiding big sell-offs can be alluring. "The predicament, however, is that the worst days are equally concentrated and just as difficult to identify in advance as the best days," Hebner notes.

The table below shows that missing the 40 worst days in the IFA SP 500 Index during this 20-year period studied (through 2020) would've increased investment returns by nearly 118% as compared to a buy-and-hold investor's gains. While increasing returns by so much sounds attractive, here's the catch: On average, an investor would've had to pick the two worst days a year — for 20 consecutive years

By contrast, investors who weren't on the right side of trades in both instances — jumping in and out — faced even more damage. As illustrated below, the flip side of the coin is that missing out on 40 of this domestic large-cap stock index's best days would've resulted in a triple-digit percentage loss. In other words, if an investor on average missed just the two best trading days each year over the course of 20 straight years, returns would go from positive to starkly negative

Our crystal ball isn't polished enough to tell us when (or, by how much) market volatility will spike again. The work of leading academics and other independent securities researchers, however, gives us confidence that IFA's portfolio construction strategy positions our clients to maximize their wealth over time on a risk-adjusted basis. 

Of course, a properly designed portfolio that emphasizes global diversification, index funds and tilts to key market factors like value, size and profitability can only do so much. If investors let themselves get spooked by short-term price gyrations, studies such as those conducted by Dalbar show this winds up disrupting investors' longer-term wealth-building goals.

Along those lines, we urge IFA's clients to take advantage of our free offer to create an individually tailored investment plan. Also, a necessary first step in our asset allocation process is to take IFA's Risk Capacity Survey. It's designed to methodically assess how much risk a person really needs to be exposed to in order to meet his or her long-term financial goals.  

Footnotes:

  1. Dalbar Inc., "Quantitative Analysis of Investor Behavior," March 31, 2021.
  2. Interview with Louis Harvey, president at Dalbar, April 21, 2021. 

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.