Much of last Friday (May 31, 2019), I received calls from a few anxious investors – seeking my opinion whether this is the time to get out of the market. In fact, some of them asked what I think about the market timing strategy – i.e., what if they sell now and get back in when the market starts rebounding.
Oh well, I told them – I don’t know whether the market has bottomed right now and if indeed, this is the bottom, I have no way knowing when it will rebound. In other words, I minced no words to affirmatively point out no one has the crystal ball about the markets.
I then was able to bring their focus back to diversified portfolios and long-term investing.
With respect to their question about market timing, I was unequivocal that I am not a fan of the strategy and countered with a follow-up question:
What would have happened if they pulled out of the market at the end of the last year ( when S&P 500 went down more than 13% in one quarter), stayed on the sidelines January to April ( when S&P returned almost 17%), and got back in at the beginning of May ( when S&P lost about 7% in the month of May alone).
Silence…..They understood my point.
The last quarter 2018 drop and then the stellar returns early 2019 is fresh on their mind, so it helped my argument. However, I want to take this opportunity, and make a more significant point – that market timing hardly works, and hence this blog post. Read on!
What is market timing?
Market timing is a very loosely defined concept. For some, it is buying investments when they are priced low and selling them when they go higher. For others, selling over-priced investments and repurchasing them when they go down. In other words, it is a “strategy” of predicting how the future markets will move and hoping the prediction is right!
If you are focused on achieving your long-term financial goals, this strategy is dumb at best. Here are the reasons why:
The strategy has a low probability of success
Let’s set aside everything else and focus on mathematical probability alone for a moment. For the “strategy” to be successful, you have to be right twice in your timing – once when you buy into (or sell out of) the investment and a second time when you sell out of (or buy into) the investment. This means, to get it right once, you have a 50 percent chance and to get it right twice, you have a mere 25 percent chance.
In fact, in this journal article, Professor and Nobel Laureate William F. Sharpe attempted to identify the percentage of time a market timer would need to be correct to break even relative to a benchmark portfolio. He concluded a market timer must be accurate 74% of the time to outperform a passive portfolio at a comparable level of risk.
Risk of missing the market’s best days
Have you ever thought about the real impact that trying to time the market can have on your returns? Due to the timing of your getting in and out, let’s say you miss out a few of the market’s best days. This could cause you to lose a significant amount of money over the long-term.
For instance, if you had invested $10,000 in the S&P 500 at the end of 2003 and stayed put through the ups and downs of the market (yes, through the 2008 market crash), you would have finished 2018 with $30,711 thanks to an annualized total return of 7.77%, according to this research by Putnam Investments.
If instead, if you tried to time the market by moving in and out and missed the best 10 days of that stretch, you’d have ended up with $15,481 on an annualized total return of 2.96% And, if you missed the 40 best days during this period, you’d have ended up losing $4,943 at a loss of annualized -4.59%! – according to the same Putnam Investments research.
In other words, staying on the sidelines just a few days in the last 15 years could mean the difference between losing almost $5,000 vs. gaining more than $30,000 on a $10,000 investment. See the point?
There are potential tax consequences
If your investments are in taxable accounts ( as opposed to tax-deferred accounts such as IRAs or 401Ks), you may have to recognize capital gains due to the sale caused by the market timing and pay taxes on them. Depending on your household income, and depending on the state you live in, this could place a significant dent into your profits you anticipate by timing the market.
Plus, remember if you held the investment for less than a year ( which is typical for market timers), capital gains are taxed at your ordinary income tax rates as opposed to the favorable long-term capital gains rates.
Now, you may be thinking – well, I am tax-smart, and I could use market timing to take a tax loss on the investment ( and then buy back the investments shortly after). Nice try, but you cannot do that – Uncle Sam has a name for that “wash-sale rule” – If you sell a security at a loss and buy the same or “substantially identical” stock or security within 30 calendar days before or after the sale, the loss is typically disallowed for current income tax purposes.
And, don’t forget the transaction costs
Market timing, by its very nature, involves frequent buying and selling, and therefore frequent transaction costs. An argument can be made that transaction costs are not too much in this day and age, but these costs add up, and you must factor them while considering the market timing strategy.
So, what do you think? Is market timing right for you? Or you rather prefer a balanced investment portfolio that focusses on achieving your long-term financial goals?
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