It is a very tempting proposition. All you have to do is get out of the market when it is at its highs and jump back in after it tanks. It sounds simple enough and has attracted many investors, both individual and institutional alike. In fact, Javier Estrada looked the Dow Jones Industrial Average (DJIA) from 1900 through 2006 which included 29,190 trading days. Missing the worst 100 days (only 0.34% of the trading days, or on average less than one day a year) you would have increased your wealth by 43,396.8%. If a passive investment in the DJIA would have yielded you $100,000 instead you would have over 43 MILLION dollars. You can see why it is so tempting.
The first problem with trying to time the market is that the prices of stocks already incorporate all available information. The people making the vast majority of stock trades work for Wall Street hedge funds, mutual funds and pension funds. These investors have access to information, regular communication with management teams and sophisticated trading technology. This is why it is safe to assume that markets are very efficient at changing prices when new information is known. It is also why you shouldn’t assume that you know something the market already doesn’t. Remember, the net sum of all these smart people’s opinions is the market price.
A recent example is when Ben Bernanke hinted that there is a possibility the FOMC could start reducing bond purchases this year (2013). Markets moved almost instantly as it incorporated this new information. New information is by definition impossible to know in advance.
Another problem is that when timing the market you have to be right twice. The first time when you sell, and the second time when you get back in (or vice versa). If you had invested $1,000 in the S&P 500 from January 1970 to December 2012 you would have $58,769. If you missed just the best 5 days of the market you would only have $38,212. If you missed the best 15 days you would only have $22,191. It is hard to believe you could lose so much missing just a few days, but markets are much more volatile than a normal distribution would suggest.
One study by Benoit Mandelbrot and Robert Hudson looked at the returns from stocks from 1913 through 2003. If the market returns behaved like a normal distribution, we would expect to see a daily market move of over 7% once every 300,000 years. However, in this 90-year period there were 48 such occurrences! This volatility where stocks gain (and lose) a lot in such short bursts makes market timing even harder. Peter Lynch was probably right when he said “Far more money has been lost by investors preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
If we accept that we cannot predict the future information driving stock prices, and stocks are so volatile we can’t afford to miss the big moves, what should we do? We first must realize what we can control and what we can’t. Unfortunately all the evidence suggests we cannot control the returns of stocks or any asset for that matter. Luckily there are many things we can control.
• We can control how much risk we take and the kinds of risk we take.
• We can control how much money we save and when we start saving.
• We can choose what investment vehicles we use, focusing on low cost and added value.
• We can manage our portfolios tax efficiently with proper placement of assets and loss harvesting
Most importantly we can develop a globally diversified investment strategy with the expectation that there will be periods of extreme volatility. Incorporating “plan B” options such as working longer or spending less in retirement prepares you for the worst case scenarios. This way when the next crisis hits you will be able to say “it’s all part of the plan”.