August 27, 2009
As Liz Ann Sonders notes in the posting below, a lot of investors are now wondering whether it’s too late to jump into the market, or, for those who have been in the market during the rally, whether it’s time to cash out. As Sonders says, such all or nothing decisions are very dangerous — and The Stingy Investor’s Norm Rothery has laid out some excellent reasons why.
In an article titled “Tempting Temptation” (originally published earlier this summer in Canadian MoneySaver but still quite relevant now), Rothery touches on a number of studies and data sets on market timing — all of which show that trying to jump in and out of the market often leads to major underperformance.
“Even normally level-headed index investors suffer from poor timing,” Rothery writes. “Morningstar.com reports that the Vanguard Total Stock Market Index fund lost 1.59% annually during the 10 years ending April 30, 2009 but index fund investors suffered a 4.04% annual decline. In this case, poor timing reduced returns by 2.45 percentage points annually.”
“To be fair,” Rothery adds, “investors in some funds get it right and a few investors are quite good timers, overall. But the odds are stacked against the average investor. Most are likely to lose roughly 2 to 5 percentage points annually, over the long run, due to poor timing.”
Another example of this bad timing comes from an article Jason Zweig wrote for Money magazine, Rothery notes. Zweig examined how mutual fund investors fared during the Internet bubble’s rise and its bursting earlier this decade. “From 1998 through 2001 the average U.S. mutual fund earned 5.7% annually but the average mutual fund investor earned only 1.0% annually,” Rothery writes. “What happened? Funds posted phenomenal early performance figures and investors loaded up. The bubble burst and they fled. As a result, most fund investors didn’t get the good early returns and instead were left with the dross of the later period.”
“The majority of investors are poor market timers,” Rothery says. “After all, bubbles get going when everyone becomes infatuated with stocks. If folks stayed away then big bubbles wouldn’t get off the ground. Similarly, crashes occur when the crowd flees in panic. This boom and bust pattern is a fundamental feature of the markets and it has been so since time immemorial.”
Rothery offers a couple tips for how investors can avoid market timing temptation. Among them: Refrain from constantly checking your portfolio. He cites data that Nassim Taleb used in his book Fooled by Randomness. “Taleb considered the case of a smart investor who earns 15% annually with 10% volatility. That is, in any one year the investor has a 68% chance of earning between 5% and 25%, and a 95% chance of earning between -5% and 35%. He has about a 93% chance of posting a gain in any year. If he checks his performance once a year, he is likely to be happy to see a profit and unlikely to be hit with a loss.
“But if he looks at his portfolio more frequently then he’s much more likely to be in the red. His portfolio has a 77% chance of being up in any particular quarter and a 67% chance of being up in a month. If he checks each day, he only has a 54% chance of seeing a day-to-day gain and he’ll encounter bad news 46% of the time. Combine the near even odds of a profit or a loss with the knowledge that losses have twice the emotional impact of gains and you have a recipe for unhappiness.”
“But if he looks at his portfolio more frequently then he’s much more likely to be in the red. His portfolio has a 77% chance of being up in any particular quarter and a 67% chance of being up in a month. If he checks each day, he only has a 54% chance of seeing a day-to-day gain and he’ll encounter bad news 46% of the time. Combine the near even odds of a profit or a loss with the knowledge that losses have twice the emotional impact of gains and you have a recipe for unhappiness.”
….SO, Checking it changes the odds of success. Whew! What color kool-aid are you drinking?
This may be the dumbest single thing I read this year. You make Market Timing sound like some kind of illness. We are market timers and our investors had DOUBLE DIGIT POSITIVE returns last year… while none-timers (passive buy-and-hopers) lost half their portfolios. Your reasoning is seriously flawed! You are doing investor a great dis-service.
If you’d like to compare portfolios, or agree to public investment competition, just let me know.
The article proves no insights to what market timing really is? Is just af gut feeling or part of some discretionary or automated trading system. There are times (typically in secular bear markets) when market timing out performs buy & hold and times when buy & hold outperforms timing (typically in secular bull markets. The problem is knowing which you are entering seeing that you can only realize it in hindsight. Market timing keeps volatility low in your portfolio and keeps you out of the biggest downturns in the market. Mabane Farber has researched this thorughly also. Many market timers fail because they lack discipline and consistency in their approach – not because market timing as such does not work.
I concur with the other comments – a simple-minded post that perpetuates the buy-and-hold fallacy. It’s been proven over and over that even the most elemental “200-day moving average” discipline (out when Index is above the 200-DMA and out when Index is below 200-DMA) produces significantly higher total returns over the long run than Buy+Hold.
Individual investors could have leapfrogged the average buy-and-holders by about 70-80% just by being out of the market during the Tech Bubble Crash and the Financial Crisis Crash by following that simple rule.
I used a similar rule in advising my blog readers to get out of the market early in January 2008 and advised them to return in May 2009. They were rewarded with a investable pool of cash 35-40% higher in May than if they had ridden the market roller coaster over the same period.
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