Time in the Market vs. Timing the Market

Recently, while waiting for my flight from Minneapolis to Detroit, I decided to read the funny pages - ahem, sorry, the personal finance magazines in one of the book stores at the airport.  What initially struck me while I read was this…in several publications, ”experts” were boldy proclaiming that ”now is the time to get back into the market,” while at the same time, in other publications, there were also “experts” asking the question, “is it too late to get back into the market?”  After reading a little more through the publications, I discovered that the supposed “experts” also went as far as predicting, for the reader’s sake, which places to put their money to maximize their potential return.

If you have become familiar with my writings over the last couple of years, you can guess my thoughts as I left the bookstore….”Time for a new blog post.”

Just about every author, in every article, discussed the importance of staying in, or getting back into, equities.   Equities are really the only area that the average investor can count on to help plan for retirement.  This, I thought, was good.  But, within all this information there lingered another issue that really bothered me.

Year-to-date (1.1.2009 - 7.30.2009), the S&P 500 is up 10.97%, and since March (3.1.2009 - 7.30.2009) the S&P 500 is up 35.62%.  At the same time, the EAFE Index - the S&P 500’s international cousin - is up 18.33% year-to-date and 46.13% since the beginning of March.

What does this mean?  Unfortunately, for investors who rely on “advice-for-the-masses” magazines, newsletters and television personalities, they have missed out on tremendous gains - gains that they may never recover. 

Trying to time the market is a fool’s errand.  The idea that individuals or computer models can accurately and consistently use market timing methods as a way to enhance investment returns is one of the greatest myths that is promulgated by the investment industry and financial media.  The truth is, market timing does not work.  If it did - or if some ONE could make it work - it would be so expensive that very few would be able to afford the service fees involved with all of the trading that would be necessary.  While the vast majority of investors try to look for cycles and patterns over time to help them predict the future movements of the markets, the evidence shows us that on a consistant basis, the market returns are random.  This may sound a little aloof, but for me to say that the one consistancy of the markets is their randomness, I better have some evidence to back that up.   So, if you want to see the evidence of this randomness in both the US and International markets, click here for Randomness in Asset Classes and click here for Randomness in Global Markets.

Investors, both average and professional, who are not yet “back in the market” say that they will get into the market when the “pull back” occurs.  That is, when the market slows down and loses anywhere from 10%-20%  of the gains it has seen since March.  While this predicted drop in stock prices may happen, the fact remains that no one knows exactly when it will happen. 

With Evidence-Based Investing, we are not worried about timing the ups and downs of the markets.  The evidence shows that in order to be a successful, long-term investor, it is imperative to stay focused on one’s time in the market, and not one’s ability to time the market.

Here is more evidence . . .

From January 1, 1970 - December 31, 2008, the S&P 500 had an annualized compound return of 9.49%.  In terms of actual dollars, if Investor A had invested $1,000 into the S&P 500 on January 1, 1970, by the end of 2008, that investment would have grown into $34,310.  However, let’s assume that Investor B, by pure  bad luck, missed the best one-day performance of the S&P 500 over a 39-year period.  Investor B would have an annualized compound return of 9.18%.  Assuming the same investment of $1,000, Investor B would have $30, 749 at the end of 2008.  So, by just missing the best one-day performance over the last 39 years, it would have cost Investor B $3,561.  Over the course of 39 years, $3,561 does not seem like that much money, so lets take a look at the same results with a different initial investment.  (To view this illustration, click here for Missed Best Day.)  Let’s say the original investment had been $100,000.  With the same returns expected for Investor A and Investor B, the difference in their investments would now be a whopping $356,100.  That is a BIG difference!

“Oh, but how likely is that?” you may ask.  “It’s just an example that has no real world, practical application.” 

Really?

Let’s look at actual data.  What if Investor B from our example above began to get very nervous (possibly even scared) in October of 2008.  Maybe Investor B’s financial professional was talking about the coming collapse of the markets, and that the timing wasn’t right to stay in.  So, he pulls his money out of the market on October 12, 2008.  The very next day, October 13, 2008, was actually the best single-day return for the S&P 500 in the last 39 years.  On that day, the S&P 500 went up 11.58%.  Investor B, frustrated that he missed 11.58% return in one day, decided that his instincts (and his financial professional) were wrong, so he gets back in the market on October 14, 2008. 

Investing is not an art, it is a science.   Evidence-Based Investing is the science of investing.

Evidence-Based Investing shows us that investors should:

1. Have a Plan

2.  Maintain Proper Asset Allocation

3.  Manage our Behavior

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