Has Your Investment Strategy Hit Your GMO Point? Thou Shalt Not Try Market Timing
Chaos Hits the Market
As investors, you regularly face tough markets. Financial downturns are unpleasant for all market participants.
When volatility shows up in markets, you usually find yourself in the middle of a crisis: 9/11, The Great Recession, COVID-19 Pandemic. Uncertainty is in the air. Job losses are happening extensively - now. The market has headed south. The financial media has all of their experts talking about what an unprecedented time this is. We cannot imagine how bad this will get. Why didn’t the government act sooner? Why didn't I see this coming and how do I get out with as little pain as possible?
Outguessing the Market Is Difficult
From February 20 to March 20, 2020, the S&P 500 Index returned –37.4%, with daily returns ranging from –12.0% to +9.4%. A drop of nearly 40% in the stock market combined with a spike in volatility can make many investors reconsider their investment approach.
Investors who hit their Get-Me-Out point pursue market timing strategies which may undermine their ability to achieve their investment goals.
The lure of getting in at the right time or avoiding the next downturn tempts even disciplined, long-term investors. The reality of successfully timing markets, however, isn’t as straightforward as it sounds.
Outguessing markets is more difficult than many investors might think. While favorable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors. Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with substantial challenges.
First and foremost, markets are fiercely competitive and adept at processing information. The combined effect of world-wide investors all seeking market equilibrium prices does not go unnoticed. You can process all of the latest market information, buy and sell from economic data and investor preferences, but it's quickly incorporated into market prices.
Trying to time the market based on an article from this morning’s newspaper, a segment from financial television or a tip from the brother-in-law hedge fund manager? It’s likely that information is already reflected in prices by the time you can react to it.
In our team’s collective experience, we know there are investors who let their emotions get the best of them. They reacted to current events and downer headlines in the wrong way and at the worst time. Poof. Years of wealth building gone on a hunch or a tip.
What if you get it Half Right?
Investors might react to a market that has fallen by screaming Get-Me-Out and jump ship and sell out of stocks. The intuition may be that sitting out of the market for a period of time can help avoid further losses. For investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice.
Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional:
“Timing markets is the dream of everybody. Suppose I could verify that I'm a .700 hitter in calling market turns. That's pretty good; you'd hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They're not. But if they were, that's 0.7 times 0.7. That's less than 50-50. So, market timing is horribly difficult to do.”
The chart below illustrates the importance of staying invested in order to capture the returns equity markets provide. Missing out on even a few of the market’s best days each year can have a significant impact on cumulative returns.
This study looked at missing just a few days out of thirty years of investing. The impact of missing just a few of the market’s best days can be profound, as this look at a hypothetical investment in the stocks that make up the S&P 500 Index shows.
Now let’s illustrate the costs of a hypothetical investor’s mistiming.
Taking a longer view, go back 50 years. A hypothetical $1,000 turns into $138,908 from 1970 through the end of August 2019. Miss the S&P 500’s five best days and that’s $90,171. Miss the 25 best days and the return dwindles to $32,763.
There’s no proven way to time the market—targeting the best days or moving to the sidelines to avoid the worst—so history argues for staying put through good times and bad. At Cogent Strategic Wealth, we believe in evidence-based investing and investing for the long term helps to ensure you’re in the position to capture what the market has to offer.
Maybe Wall Street Knows Better?
As an individual investor with a little bit of humility, you might think something like, “I am great at what I do, but I am not a professional mutual fund manager. They must have a crystal ball and see the train coming a mile away.
When it comes to professional money managers with MBAs or PhDs in Finance from the best schools and having access to unlimited resources to out-guess the market, it isn’t as easy as you’d think.
The researchers at Dimensional Fund Advisors recently studied the performance of actively managed mutual funds and found that even professional investors have difficulty beating the market. Over a recent 20 year period, 77% of equity funds and 92% of fixed income funds failed to not only survive but outperform their benchmarks after costs. That leaves you with almost a three-out-of-four chance of not even beating a simple index fund, and paying higher fees to the fund manager.
Overpaying and under-performing is not a formula we advocate.
Some investors might look to professional managers for a more alluring protection from down markets. After all, who has not heard the claim that a volatile market is precisely the environment in which many traditional active managers thrive? But is there any truth to this claim?
We again looked at the performance of active US mutual fund managers over the past two decades. We considered two different ways of measuring stock market stress: market volatility (or how much stocks rise or fall in a given month) and return dispersion (or the range of returns across all US stocks). Stay with us here, as it gets a little wonky.
In each case, active managers underperformed their index benchmarks. It would seem promises were not met.
Let Evidence Be Your Guide
We empathize with those who feel they should be reacting to ongoing bad news or that really juicy tip that will make you rich quickly. But our advice has always been based on scientific evidence, not on our opinion (or others) about the market’s next moves.
Time-tested, peer-reviewed evidence-based investing does not offer perfection. Nothing does. But it is the most reliable guidance available to us. How would you feel about a doctor who gave advice based exclusively on their opinion, without considering new or updated medical research? In finance, new research is vetted and published in professional journals such as The Journal of Finance and the Journal of Portfolio Management upon which we can and should base our advice.
And while the particulars of current events are always at least a little different than what we’ve seen in the past, we standby by our evidence-based strategy. In fact, we invest our personal assets in the same way. We might occasionally even share in the FOMO and allure of investing in the wild ride of the market or the “GMO!” temptations when the market looks bleak. But we know better than to succumb to them.
So What Can You Do?
The most successful investors were those with a financial plan and who didn’t deviate from that plan when high volatility showed up. They leaned on the experience derived from multiple decades of evidence-based investing history and research.
Investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on what you can control (like having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes), investors can better position themselves to make the most of what capital markets have to offer.
If you want to achieve your long-term financial goals, you must be willing to ride through temporary declines to participate in the advance of equities of the world’s companies over the long term.
Especially when markets head south, it can be hard to trust that your best course of action is to do nothing, at least when it comes to your trading habits. It can be even harder to stay staunchly inactive when things seem to be going from bad to worse.
The Last Word
There aren’t many investment rules that are set in stone; most of them come with exceptions, caveats and qualifications. That said, with more than seven decades of academic evidence, plus our own experience through years of volatile markets, we can confirm: Thou shalt not try market timing.
Don’t leave your financial future to chance. You have spent your entire life working hard and accumulating the wealth that is the foundation of your life now and to come.
At Cogent Strategic Wealth, we offer clarity through the (financial) crisis. We help high-achieving individuals develop clear goals for securing their financial future. Let us help you navigate the current financial crisis and come out the other side.
Schedule a consultation today and let the team at Cogent Strategic Wealth work with you to create a plan to help you achieve your financial goals.
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