Many investors still think they can successfully time the market, selling before a decline and buying on the recovery. Some are lucky enough to do it successfully a couple of times, believing it was a skill, not luck. Others listen to so-called market gurus who were right a couple of times and now seem prescient. (Our favorite analogy is someone who hits heads 20 times in a row in a coin toss; that may seem impossible, but it does have a tiny chance of happening, but it could. Now multiply that person by 100,000 people tossing coins, and the odds of someone getting heads 20 times In a row is a much more distinct possibility. Liken that to the hundreds of thousands of people who attempt to time the market; occasionally someone will time it precisely right, suddenly they are the new market “experts” when it was mostly just luck.)
Unfortunately, in our years of experience, we have not seen anyone who could consistently call market declines and recoveries.
Any active traders seeking to time the market may sabotage their performance if they miss out on any of that small handful of days. If you stay invested, you’re implicitly “buying” on down days. If you get too active, you risk buying high and selling low. Studies have repeatedly shown that retail investors who believe in market timing almost certainly lose money! Timing has been shown repeatedly to be a flawed strategy, and the math behind probability demonstrates why. Consider that market timing entails two decisions, when to sell and when to buy back in. Ignoring essential details, including the fact that these are not independent decisions (which they are not), to calculate the probability, it is .5 times .5 or a 25% chance of getting both the decisions right. This is one in four bets you will not lose money. Many market-timers don’t understand the odds heavily stacked against them. In reality, It is a minimal chance, less than a 5% chance you can make a profit with this strategy, and even smaller if you make further bets. These are not good odds. A better approach is the one we use to invest in a very diversified and flexible strategy.
Deciding when to sell and when to move back is a difficult challenge if you look at what happens during market declines and recoveries:
|Last Month Decline
|Recovery Return First Month
|Recovery Return First Three Months
|1998 Long Term Capital Crash
|2008 Housing Crises
Market declines are frequently worst in the month preceding a recovery. The recoveries are most impressive in the first month, and returns are typically the highest in the first three months of the recovery. You can see why it is so difficult to time this. If you sell at the wrong time, you capture much of the loss; if you fail to move back into the market early on, you miss much of the recovery. Missing those first three months of the recovery impacts your return forever; you will never get back the 20-26% in return you missed. Lessons learned:
- Most bear markets last 18 months or less
- In many cases, the decline is fast and furious
- In nearly every case we studied, the recovery is fastest in the first 1-3 months.
- Market returns are very high during the recovery phase.
- Timing the market requires two correct decisions – when to sell and when to repurchase.
- That decision is further complicated for a taxable account with significant embedded gains.
Instead of trying to time markets, diversify across many asset classes, use the science and mathematics behind Modern Portfolio Theory to make your portfolio “efficient” (the most return for a given level of risk). Well-designed portfolios will experience less downside risk and a smoother path for your wealth.
In the video which complements this blog Laura and Steve discuss this in more detail: