Glasses of water

Missing the Best and Worst Days

Glasses of water

Big down days and big up days frequently come right next to each other. This is volatility—and it is why you have to stay in the markets to get the markets’ superior return.

The chart below shows the returns of the IFA Index Portfolios in the year that followed the bottoming of the market on March 9, 2009. One year later, to the day, we see that investors who pulled out of the market in early 2009 and remained terrified about getting back in, missed out on a 102.52 % gain on our IFA Index Portfolio 90, which is IFA’s full-equity portfolio.

To better visualize just how hard it is to find the 20 best or worst days, here is an image of the whole period used in a prior similar study.

calendar


In a January 24, 2009 article in the Wall Street Journal, titled " Why Market Forecasts Keep Missing the Mark," Jason Zweig recounted how difficult it is to predict the future direction of the market. In the article he states, "History shows that the vast majority of the time, the stock market does next to nothing. Then, when no one expects it, the market delivers a giant gain or loss -- and promptly lapses back into its usual stupor. Javier Estrada, a finance professor at IESE Business School in Barcelona, Spain, has studied the daily returns of the Dow Jones Industrial Average back to 1900. I asked him to extend his research through the end of 2008. Prof. Estrada found that if you took away the 10 best days, two-thirds of the cumulative gains produced by the Dow over the past 109 years would disappear. Conversely, had you sidestepped the market's 10 worst days, you would have tripled the actual return of the Dow. "Although we could make a bundle of money if we could accurately predict those good and bad days," says Prof. Estrada, "the sad truth is that we're very, very unlikely to do that." The moments that made all the difference were just 0.03% of history: 10 days out of 29,694."

The odds against success in picking the right times are overwhelming, and the odds become worse over time with the high taxes and costs associated with frequent trading.

Professor Hersh Shefrin took a look at some very interesting behavioral finance issues about investor's perceptions of how markets work. In surveys of both individual and professional investors, he discovered that neither one understood that last year's return had no predictive value for the next year. Individuals tended to think there was a positive correlation, meaning that one bad year is followed by another bad year and one good year is followed by a good year. Professional investors tended toward the opposite point of view, thinking that one good year tends to be followed by a bad year and visa versa. The fact is that they are both wrong. As indicated by the very low R2 in the third figure below, no previous period was a predictor of the subsequent period. Shefrin also explores the investors lack of understanding of how risk has a positive correlation to returns, meaning more risk begets more return over the longer periods like 10 years. He stated, "...investors have a good sense of what makes up risk, but a poor sense of how to connect that to expected returns." (see his paper, Behavioral Finance, by Hersh Shefrin, CFA Institute, June 2007, pages 1-7)