Monday, October 13, 2008

Market Timing Dangers

Today's sharp move higher in the stock market sheds light on the dangers of an investor trying to time the market. I wrote a post earlier this year, Focus on the the Long-Term, in which it was noted missing just a handful of the market's best days in a given year can really penalize returns. If an investor missed just 40 of the biggest up days in the market over the last 20 years (1987-2007), their return would have totaled 3.98% versus remaining fully invested and achieving an average annualized return of 11.82%.

The market research firm DALBAR went one step further and looked at the returns of mutual fund investors over the 20-year period, 1986-2006, and reported the average market timer return was -2%. During this same time period, the S&P 500 Index returned 12%.

market timing chart December 2007
  • Additionally, during the 10-year period 1997-2006, the S&P 500 Index achieved an annualized return of 8.4%. If an investor missed just the top 20 days during this period, their return fell to -.4%.
  • Further, 21 of the best 40 days came during the bear market period 2000-2002.
  • Lastly, nearly three-fourths of the 40 best days came within two weeks following a worst market day.
A key investment decision for an investor should be to review their overall asset allocation. If the review, and investor risk tolerance, indicates additional equity exposure is appropriate, then maybe now is a good time to begin averaging into the market.


Market Timing Doesn't Work
Charles Schwab OnInvesting
By: Liz Ann Sonders
Fall 2007

Volatility and Complacency Make Strange Bedfellows
Charles Schwab OnInvesting
By: Liz Ann Sonders
Summer 2007


Pawan said...

I do not understand one thing in this timing study which is what points do the reckon the person attempting to time the market entered the markets? Did they assume such a person failed 50% of the times? Or 100% of the times?

David Templeton, CFA said...

Much of the data is available through mutual fund trading data. In fact, it has been proven that the "average" investor returns significantly underperform the performance of the investor's respective mutual fund. In the 19-year study ending 2002, the DALBAR study noted,

The average equity fund investor earned only 2.57% annually over the 19-year period included in the study, compared to annualized inflation of 3.14% and the S&P 500 Index average annual return of 12.22%. The average fixed income (bonds) mutual fund investor fared a little better, but not up to the market’s performance. Over the last 19 years, the average fixed income mutual fund investor had an annualized gain of 4.24% versus the long-term government bond index which averaged 11.70%.

Anonymous said...

David: that was an excellent read! thanks for sharing it!

Anonymous said...

While I am skeptical of the ability to time a market, it is not because of one sided arguments like this. While you note the that missing the large up days hurts returns, in part that is because you need those big returns to make up for the big down days as well. Imagine a timing system which missed those biggest up days ... but also avoided ANY down days. The returns would in fact be better than the market averages. Clearly, there is no such system that perfectly misses all the down days. But you describe a system that perfectly misses only the biggest up days and nothing else. That is equally unlikely. However, it is an all too typical misuse of statistics like these that lead the average investors to make the wrong choices. If you want to understand if "timing works" you must examine the returns of a given approach, not some hypothetical situation. Incidentally, this same comment applies not just market timing, but to any investing approach .... you need to consider actual real returns, including commissions, and actual performances, not some hypothetically created statistic to understand if that approach (timing, value investing, growth, etc) will beat a straightforward indexing approach.

David Templeton, CFA said...

anonymous. I agree with a lot of what you say. I believe the point in looking at market timing studies is the average investor tends to time in and out of the market at the wrong part of the market cycle. There is an interesting post on The DIV-Net site,
Mutual Fund Returns Versus Individual Investor Returns

that you might find of interest.