Stock Market Timing: Systematic Losses

Posted on September 24, 2012 at 12:02 PM PST by

How many times have you overheard someone brag about their uncanny stock market timing? “Boy, I got out of stocks just in time!” or “We sold at nearly the high, thank goodness.”

Stock market timing sounds like an easy way to get rich. You buy low and sell high, then wait for the inevitable opportunity to double your money again. What could be easier?

Recent history seems to lend credence to stock market timing as an investment strategy. Back in the depths of the market crash, in 2009, a lot of people took money off the table. Unequivocally, many have missed a chance to make their money back and some gains: Stocks are up 107% from the Dow low, not counting three-and-a-half years of intervening dividends paid out.

stock market timing

Of course, it wasn’t as obvious at the time. Even super safe investments such as money market funds were crashing. Investors who had spent the previous few years soaking up high risk soon plunged instead into Treasury debt in abject fear. That trend continues, even now.

Nevertheless, data show that everyday retail investors still aren’t back into risk assets — they’ll stick with their cash and Treasuries, thanks. Which raises an interesting question: At what point do the mom-and-pop buyers flood into stocks, or will they come back at all? Is stock market timing totally dead?

Dalbar, the research firm, has spent a lot of time documenting what we actually do, collectively, about our choices. Turns out, we’re pretty terrible at guessing what will happen next in the markets.

In the firm’s latest Quantitative Analysis of Investor Behavior, Dalbar researchers show that people are, by their nature, just awful at stock market timing. A typical investor in mutual funds underperformed the S&P 500 Index by 4.32% on an annualized basis over 20 years.

Bond investors did worse, off by 5.56% annually vs. the corresponding index. (The numbers include fees and expenses — but also dividends and unrealized gains — as represented by mutual fund data from the Investment Company Institute.)

In effect, a simple purchase of the S&P 500 yielded gains of 7.81% a year, on average, over two decades, while market timing using mutual funds gained just 3.49%. The Barclays Aggregate Bond Index gained 6.5% a year, while the typical investor managed just 0.94% a year in gains — negative after inflation.

What’s worse, active equity and bond investors lagged the indexes in every time frame: 12 months, three years, five years, 10 and 20. They simply never got it right.

Consider what the cumulative effective of compounding means for long-term investors. A stock investor compounding at 7.81% a year on a quarterly basis would see $10,000 turn into almost $47,000. The typical market timer dashing in and out of stock funds ends up with just over $20,000.

Here’s the magical part: Assume you wait just 10 more years at the higher, benchmark return. Your $10,000 is now pennies shy of $101,800.

The market timer? That person has $28,362. That’s more than three-and-a-half times less!

Let’s make it a little more interesting. Say you had $100,000 invested. At the 3.49% compounding return, you enter retirement with $283,618. So far, so good.

At 7.81%, the final number is comfortably over $1 million. Just compounding, no additional saving.

Stock market timing in the big leagues

USA Today noted recently that the trend of poorly advised, misguided individual investing has held up right into recent weeks. Its review of Lipper data found that the S&P 500 is up 4.1% since the previous high point in 2007, once you count reinvested dividends.

Largely because of the drag of expenses, the newspaper explained, just 42% of stock funds can say they did better:

The average U.S. diversified stock fund charges 1.28% in expenses every year. To beat the S&P 500, funds have to beat the index plus expenses — something few managers can do consistently.

To win at stock market timing, you would, in advance, have to predict which funds would outperform and which would not and then be invested in only the winners and only at the right times. Pretty tall order.

Long-term or short, big portfolio or little, the risk inherent in stock market timing is hard to appreciate. You might get lucky once, twice, even three times. Then you would blow it all on that fourth — and final, for you — fateful spin of the wheel.

Meanwhile, inexpensive ETF and index funds churn on. Coupled with robust, yet simple, asset allocation, passive investing can be calming, even snore-inducing. But it works at precisely the moments when stock market timing so predictably fails.