Tuesday, December 8, 2009

Timing the Market

Pathways Advisory Group, Inc.
Dustin Smith, CFP®

The past 24 months have been challenging. Investors who fled to safety missed out on significant gains. Investors who stuck to an asset allocation endured mounting losses and sleepless nights. It has not been easy - for anyone. Many investors are searching for a better way.

A typical conversation goes something like this:

Investor: Looking back on the past two years, what would you do differently?

Advisor: That’s easy - I would have cashed out in 2007 and bought Gold. I would have returned to equities in March and margined the account.

Investor: Does that mean you will suggest an exit strategy next time?

Advisor: Unfortunately, it doesn’t work that way. Market timing is like Monopoly - the traps are different every time you play. Landing on Park Place may be safe this time but next time it will cost you. Monopoly, however, isn’t real.

For me, the search for a better way stumbles on the same two issues each time. First, markets are unpredictable. Second, missing out on returns can ruin a financial plan.

  1. Predictability: Every day we hear predictions from the experts. Some get it right. More get it wrong. Economist Paul Samuelson said it best: “The stock market has forecast nine of the last five recessions.” One piece of evidence published each year is the Standard and Poor’s Indices Verses Active Funds (SPIVA) report. The 2008 year-end report shows 72% underperformance of the S&P 500 Index by actively managed Large Cap funds and 85% underperformance of the S&P Small Cap Index by actively managed small cap funds for the five-year period ending in 2008 (www.spiva.standardandpoors.com). This is typical - the majority of “experts” do get it wrong. The past 11 months have also been particularly humbling. The S&P 500 is up more than 50% since March 9, 2009. The Vanguard REIT Index is up more than 80% during the same time period. Who predicted that? I did not. The experts did not.
  2. Missing out on returns: Jumping in and out of the market can be very costly. The following simulation from our Investment Philosophy Statement (available under the investment philosophy section of our web page: www.pathwaysadvisorygroup.com) offers an extreme example of the risk of these timing decisions - market gains are concentrated in sharp upward bursts.
One dollar invested January 1, 1926 in the Standard & Poor’s 500 would have grown to $2,047 by December 31, 2008. This represents an average return of 9.6%. If you had simply not been invested the best month out of each calendar year, your one dollar investment in 1926 would have grown only to $2.46 over the following 83 years. That’s an average of less than 1.25% return. The results are even more dramatic with small company stocks. Investing a dollar in the small company index The Center for Research and Security Prices (CRSP 9-10 Index) in 1926 would have grown to $8,690 by the end of December 2008 - an average of 11.83%. If you had simply not been invested the best month out of each calendar year, your one dollar investment in 1926 would not have even grown over the 83 years. Your dollar would have reduced to just 10 cents.

This is an extreme example to make a point. Nobody could time it exactly wrong - although some people feel that unlucky. The point, however, is the majority of the returns the last 83 years came in less than 10% of the days invested. Returns come in sharp upward bursts - missing out can jeopardize a financial plan. It’s not just missing returns; it’s missing out on the future compounding of those returns. Thus, the penalty is hugely magnified.

Many are searching for a better way; I just don’t see one. Nick Murray, veteran advisor and columnist, said it best:

Churchill famously said that democracy is the worst form of government ever formulated by man, except for all the others. Buy-and-hold is, in exactly the same sense, the worst equity investment strategy ever devised by man. Except for all the others.

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