The Other Side of the Story of Market Timing

Market timing is a misunderstood concept when it comes to investing. The mutual fund industry defines market timing as a process of attempting to perfectly time the tops of markets (before a market declines) and perfectly time the bottom of stock market declines (before the stock market goes up).

In other words, an investor is trying to sell at the perfect time and buy at the perfect time. The mutual fund industry doesn’t want you to time the market. Thus, they came up with a perfect example of why market timing is a disastrous strategy.

The basis of their argument is that if you try to time the market you might miss the best days of the month or year. If you miss those days when the market has big gains, then your overall investment return will really suffer. So they publish these studies.

Barron’s Magazine published an article that showed what an investor would have made if invested in the S&P 500 index from February 1966 through October 2001. During that 36-year period, an initial investment of $1,000 would be worth $11,710.

A study done by Birinyi Associates performed a complement study to the one in Barron’s. They stated that if an investor missed the five best days every calendar year, the $1,000 would have shrunk to $150.

That is pretty convincing. An average investor would look at that statistic and conclude that market timing is a horrible strategy. Why would you want to try and pick when to be in the stock market and when to be out of the stock market? If you just missed a few good days, you might miss the entire opportunity.

I ran my own study. I wanted to know what would happen if you missed the worst months to be in the stock market. So, I took a look at the S&P 500 between January 1950 and December 2007.

If you invested $1,000 January 1950, it would have grown to $613,013 by December 2007.

If you missed the 30 best months, that $1,000 would have turned into $35,404. If you would have just stayed invested and not tried market timing, your $1,000 would have turned into $613,013. Instead, you tried to market time and ended up with only $35,404.

What if you would have missed the 30 worst months between January 1950 and December 2007?

If you missed the 30 worst months, your $1,000 would have turned into $9,509,094.

Which do you think is more important? Being in there for the gains or protecting yourself in the bad markets?

This isn’t about market timing and trying to pick tops and bottoms of the market. This is about protecting your investments when stock market risk gets high. Remember you reduce risk as you reduce the amount of money invested in stocks.

When you experience excessive losses, it just takes so much time to gain back the loss.

Loss..........% Required to Break Even
-10%........ +11%
-20%........ +25%
-30%........ +43%
-40%........ +67%
-50%........ +100%
-60%........ +150%
-70%........ +233%

If you were to lose -40%, it would require a return of 67% just to get back to even again. It would take a long time to achieve that return. This is why risk matters and having a risk strategy is extremely important.

Now obviously neither you nor I are going to be able to look into the future and pick good and bad days in the market. This is just to illustrate the impact of loss on a portfolio. This is primarily directed towards investors who stay heavily invested in stocks. At some point you have to start taking profits and get your portfolio balanced and properly diversified. The problem is that most people are not properly diversified.

If you’re concerned about your investments, you can email me through AskBob.

Copyright © 2008 Prudent Money and Bob Brooks. All rights reserved.