by Andrew Murphy, CFA | Senior Director of Portfolio Management DOWNLOAD/PRINT What are the costs of market timing…
JULY 2021 CLIENT QUESTION OF THE MONTH: MARKET TIMING DOES NOT WORKClient Question of the Month |
by Andrew Murphy, CFA Co-Chief Investment Officer
In our July Client Question of the Month, we thought it would be helpful to assemble our favorite charts on market timing. As a wealth management firm, market timing is one of our most frequently discussed topics.
Market timing is an investment strategy that is implemented by selling a large portion of equity holdings when the market is high (keep in mind this could result in substantial capital gains for taxable investors), patiently waiting on the sideline as the market declines, reinvesting at the market low, and then riding the market back up to new highs. Rinse and repeat. Although this might sound easy, the reality is that successful market timing is nearly impossible to execute consistently. Market tops and bottoms are never obvious in real time, only in hindsight. To execute a market timing strategy an investor must get two decisions precisely correct: when to sell out of the market and when to buy back in. Most investors come up short with the second decision, buying back in. We will note that if an investor discovered the magic formula to market timing, they would essentially be able to make an unlimited amount of money. There is no magic formula.
Market timing decisions are often emotional decisions driven by fear or panic rather than fact-based analysis. Given the damaging impact that market timing decisions have on performance, the average investor should look for ways to mitigate this behavior. A trusted financial advisor can help make rational and data driven decisions rather than ones based on emotion. In our experience, the best course of action is to combine comprehensive financial planning with a globally diversified portfolio constructed by a thorough investment process.
At Winthrop Wealth, we follow a total net worth approach to wealth management that combines both comprehensive financial planning and investment management. While financial planning and investment management can function successfully on their own, the combination produces a whole greater than the sum of its parts. The financial plan defines cash flow needs, optimizes account structures, considers tax minimization strategies, and determines the appropriate asset allocation based on the client’s willingness and ability to take risk. Based on the output of the financial plan, our investment management process designs a well-diversified portfolio constructed with a methodology based on prudent risk management, asset allocation, and security selection. We ensure that our client’s short-term cash flow needs are met while constantly stress testing both their financial plan and investment portfolio to help them ultimately reach their longer-term goals and objectives despite challenging markets. Without a comprehensive financial plan and investment process, it is very easy to shoot yourself in the foot by making an emotionally based market timing mistake.
Successful investing requires skill and discipline, not reliance on gimmicks like market timing. We hope that the following slides cement that market timing is a loser’s game and should not be relied upon as a serious investment strategy.
The stock market goes up over time
From 1928 to 2020, the stock market produced a total annualized return of +9.6%. A $10,000 investment in 1928 would have increased to over $48,000,000 at the end of 2020.
We would also like to highlight that this period includes several of the most challenging market environments in history, including, the Great Depression, World War II, 1970’s Stagflation, Crash of 1987, Dot-Com Bubble, Global Financial Crisis, and the Covid Pandemic. The total period includes eleven bear markets, fifteen recessions, and dozens of corrections and pullbacks.
The stock market rewards long term investors.
The stock market goes up over time, but returns are not linear
Since 1928, the stock market produced positive results in 68 calendar years vs. 25 years with negative returns.
The market went higher in 73% of years with an average return of +20.8% and declined in 27% of years with an average drop of -14.0%.
Market declines are common
The following chart displays the S&P 500’s annual return vs. the largest intra-year decline from 1980 through 2020.
Over this period, the S&P 500 has generated a total annualized return of +12.0%. Annual returns ranged from -37.0% to +35.5%.
There were plenty of market drops along the way as the average intra-year price decline was -14%. This simply means that at some point each year the S&P 500 dropped by an average of -14%.
There are always “reasons to sell”
An old investment adage is that the stock market climbs a “wall of worry.” This simply means that the market has risen over time despite a constant barrage of potential risks that could cause a correction or decline.
The market always has risks to overcome and there is never an “all-clear” signal.
The 24-hour news cycle and advent of social media might make it seem as though risks are more prevalent today, but they have always existed. Historically, you might not find out about economic data or company specific news until you read about it in the newspaper the next day. Now everything happens in real-time, with a never-ending flow of pundits and articles ready to pontificate about what happened and how it may impact the markets.
We caution our clients to not overreact to one data-point, piece of news, or what a so-called market authority might be predicting.
Missing the best days crushes investor returns
Investors who wait on the sidelines for the “optimal” time to buy often miss significant rallies.
A $10,000 investment in 1980 would have increased to about $1,030,000 at the end of 2020. Note, this period includes over 10,000 trading days and assumes the individual stayed fully investor. If an investor missed only the 10 best days in the market, their total return would have been less than half. If an investor missed the 40 best days, their return would have been about one tenth.
To make things more difficult for market timers, the best days often occur during periods of severe market stress. Nine of the ten best days in the market over the last forty-one years occurred during either the Global Financial Crisis (2008-2009) or the Covid Pandemic (2020). Nervous or frustrated investors who threw in the towel would have missed the subsequent market rebound and devasted their portfolios.
During periods of market stress, it is impossible to know when the market bounce will occur, but we do know that missing the bounce can have a severe negative impact on total return.
The average investor underperforms due to market timing
The following chart is from a Dalbar study titled “Quantitative Analysis of Investor Behavior” that displays the annualized returns of various asset classes and the average investor for the twenty-year period of 2001 through 2020.
The average asset allocation investor’s return is based on an analysis of the net aggregate mutual fund sales, redemptions and exchanges each month. The study shows that the average investor’s return over this period was less than half of stocks and far worse than a bond portfolio.
Dalbar cites market timing as a main factor for poor investor performance.
Remember the benefit of diversification
Diversification and time are an investor’s two best friends. Diversified portfolios can lead to more consistent and less volatile results than a single asset class. We know that markets can be extremely volatile in the short-term but difficult periods do not last forever.
To highlight the benefits of diversification, we examined the total return performance of nine separate asset classes and a diversified asset allocation portfolio from 2006 to 2020. From year-to-year many asset classes rotate from top to bottom performers, while the asset allocation portfolio consistently stays the middle.
Remember the value of time
The following chart displays the performance of various stock and bond portfolios over rolling periods. Our time-period runs from January 1976 through December 2020 – this is the longest possible data period we have for both the S&P 500 (stocks) and Bloomberg Barclays Aggregate Bond index (bonds). Rolling periods run from month-to-month over the stated time frame and allow for a larger data set than calendar year periods.
As the rolling time-period increases, the value of the lowest return increases and the range of outcomes (high – low) decreases. Markets can be extremely volatile in the short-term and equity drawdowns can be severe and occur suddenly.
The longer the investment time horizon the greater the odds of positive returns. Time invested in the market matters more than market timing.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Likewise, it is important to remember that no investment strategy assures success or protects against loss. Past performance is no guarantee of future results. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
Rebalancing a portfolio may cause you to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
All indexes mentioned are unmanaged indexes which cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The S&P Midcap 400 Stock Index is an unmanaged index generally representative of the market for the stocks of mid-sized US companies.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The prices of small cap stocks and mid cap stocks are generally more volatile than large cap stocks.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays US Treasury Bills 1-3 Month Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months. The Index includes all publicly issued zero coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and at least 1 month, are rated investment grade, and have $300 million or more of outstanding face value.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Bloomberg Barclays Capital US Corporate High Yield Bond index is an index representative of the universe of fixed-rate, non-investment grade debt.
The Bloomberg Commodity Total Return index is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM. This combines the returns of the BCOM with the returns on cash collateral invested in 13 week (3 Month) U.S. Treasury Bills.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
“https://www.bloomberg.com/quote/BCOMTR:IND#skip-taboola-ads”The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.