How Market Timing Destroys Wealth
As the market reaches all-time highs again, it is the perfect time to prepare clients for the next market correction. Investors often believe that they can “time the markets” by simply “buying low” and “selling high”. As reasonable as that sounds, not even the best investors on the planet have been able to consistently time the markets correctly, so it makes one wonder why anyone would try to “play the losers game?”
Of course, there are those “market sages” like Elaine Garzarelli who worked at Lehman Brothers in the 1980’s and made a career out of calling the market correction in the fall of 1987, when the market went down -22.6% in a single day. However, many of us have forgotten about her since that one call was never followed up with a consistent track record of other accurate predictions. In fact, many analysts may get it right on the “sell” but rarely get it right on the “buy,” or vice versa, but their calls are sensationalized in the media. The fact pattern is quite clear that no one, not even Bill Miller, John Neff, Carl Ichan, Ken Griffen, Ray Dalio, Seth Klarman, Bill Ackman, Lord Keynes, Peter Lynch or even Warren Buffet have ever been able to call the markets correctly consistently, yet they have all become famous for being highly successful investors. How did they achieve this level of sustained success?
They all managed different asset classes and had different approaches, but one common theme was that they did not even try to time the markets. They developed a strategy, and a style of investing and stayed with it for the long run. Of course they made adjustments along the way, but nothing so dramatic as trying to step in and out of the market. In fact, that is the one way that any investor can reliably destroy wealth for themselves and their clients.
Given all of the above, why do some continue to try to time the markets? Unfortunately, it is natural human emotions that override what is logical by trying to do what we all know is impossible. For example, when stocks decline, investors are fine with a 15% correction, but usually start to panic when they get to the 30% range, and then sell at or near bottom to “protect” their remaining assets. However, what they are typically doing is “locking in their losses” as corrections invariably reverse direction over time. On the other hand, when the market is hot, investors are gripped with FOMO (fear of missing out) and end up buying stocks when they are already overpriced. Human nature seems to be wired to “buy high” and “sell low” rather than what is most rational.
If we could only control those emotions, it still would not matter, because we could not consistently predict when the market is at a high or low!
Before we provide some insight on the best approach to building wealth and managing risk, let’s look at why it is so difficult to consistently predict the peaks and troughs in the market.
Bear Markets – (1987-2022)
The chart below shows that there have been eight “bear markets,” as defined by corrections with over a 20% decline, over approximately the last 35 years. It is helpful to see how long they lasted, the magnitude of the decline, as well as the biggest declines over one and five days.
There are a few interesting points from the table:
▪ Most bear markets were very short – 5 had a duration of 1-4 months.
▪ Most had double-digit declines over a five-day trading period.
▪ Most had one-day declines of more than 5%, with two of them experiencing double-digit single-day declines.
▪ The worst one-day decline was the 1987 “flash crash” with a decline of -20.5%.
The key point is that shifts can occur very rapidly and violently, in both directions, during a market correction. To have a chance at “winning the losers game,” you need to be perfect on not one, but TWO crucial decisions: when to get out and when to get back in. If you are off by one day on either decision, you will see in the next section that the results can be quite disastrous for your portfolio.
Missing A Day Can Cripple Performance
As highlighted above, a significant percentage of gains and losses happen over a short period of time, and missing these major up or down days can significantly impact returns in the long run. The challenge is that it is equally hard to predict when the market will have a good day as when it will have a down day, and some of those up days come in bear markets.
The data above has a few interesting takeaways:
▪ Most up days come in “bear” markets.
▪ Around 75%-80% of market swings take place in a relatively short period of time.
▪ These major movements are often highly unpredictable.
▪ A disproportionate percentage of total gains in bull markets occur rapidly at the beginning of market recovery.
▪ At best, missing these days will result in significantly reduced portfolio performance, or severe losses at worst.
J.P. Morgan recently conducted an asset management study that focused on the S&P 500 from 2001-2020, and it suggests that a buy and hold strategy over nearly two decades would return +7.47%. However, missing the best 10 days almost halved this return, and missing the best 50 days over the 20-year period produced a -5.21% return. They go on to conclude that “even with great skill and extraordinary capability, it is almost impossible to harness high magnitude returns fully, making market timing an approach that is very challenging, if not impossible, to implement successfully.”
Taxes & Trading Costs
If an investor was able to beat the odds and have some success in timing the markets, they still may not have accomplished the mission because there are costs associated with chasing performance. Capital gains taxes and other transaction costs will erode some, if not all, of the benefit of gains. According to Boston-based research firm Dalbar, those expenses can result in underperformance of up to 3% on transaction costs alone. (Source: Dalbar Quantitative Analysis of Investing Behavior 2021).
Conclusion
Attempting to time the market has a very low chance of success for even the most experienced investors. And even if short-termgains are made, they will likely be eliminated by the real costs of a market timing approach.
We believe that investors should focus more on their time in the markets rather than market timing. Markets generally rise overtime, so it makes little sense to try to “win the losers game” when a steady approach is far more likely to lead to investing success. The most effective way to build wealth and manage risk is to develop a disciplined strategy to meet specific long-term goals and to let the power of diversification, compounding and time achieve those objectives.
It is an approach that has been used by the most successful investors in the industry, including Warren Buffet and the other legends referenced earlier.
Warm regards,
The Pension Wealth & Management Team
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