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. 

Of late, major financial publications across the country have been warning of severe repercussions for investors after an outset of coronavirus cases. 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 blue chip 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 that a typical U.S. stock mutual funds investor through 2019 had underperformed by nearly five percentage points a year over the past 30 years by mistiming moves in and out of markets. While the S&P 500 Index had returned an average 9.96% over that period, Dalbar estimated an average stock fund investor actually realized just 5.04% a year.1  

"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," the independent investment analysis firm'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 a 20-year period (through 2019) would've increased investment returns by nearly 991% as compared to a buy-and-hold investor's gains. While increasing returns by so much sounds attractive, 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 blue chip stocks' 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 market volatility will spike again. But academic research tells us that a globally diversified portfolio that's rebalanced over time gives an investor the best opportunity to capture the highest expected return. 

So what is an appropriate asset allocation for each investor? 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 2020.
  2. Phone interview by IFA with Louis Harvey, president at Dalbar, 03/04/2020. 

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