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When Timing Isn’t Everything: The Folly of Market Timing

Many of us remember going to batting cages as kids. Oftentimes, the cages would vary with respect to how fast the pitches would come, with the fastest of the cages boasting speeds of up to 60 or 65 miles per hour. The ball was practically a blur at that speed; just imagine what it must be like to hit a major league pitcher.

“The average investor’s return is significantly lower than market indices due primarily to market timing.” — Daniel Kahneman

Whether the subject is a trip to the batting cage, the delivery of a punch line at a cocktail party, or the launching of a rocket, the world around us is filled with examples of when to take action and when to watch a situation unfold. The need to get the timing right is everywhere.

Yet there are unique aspects to the practice of investing in publicly traded securities that often render timing counterproductive. In fact, the urge to time the market—the notion that there are times to own stocks and times to be completely out of stocks—seems simplistically intuitive but can be a ruinous inclination. This paper critiques the notion that individual investors can, through research or instinct, figure out when to be in and when to be out of the market. It also looks at timing practices that might make sense and concludes with a recommendation for investing that keeps the urge to time in its proper place.

Missing The Boat

In our experience, investors tend to miss the timing boat in two ways: on day-to-day bases and over longer-term trends.

The short-term miss happens because investors routinely fail to recognize that positive returns over the course of a year actually accrue in a very small number of daily returns. To illustrate, we looked at the price returns on the exchange traded fund “SPY,” which tracks the performance of the S&P 500 Index. We analyzed the performance over the one-year period of November 16, 2012, through November 15, 2013, and found the price return for this period was exceptionally strong: 28.96%. That’s not bad for only 252 trading days.

Actually, it’s even better—or worse—than it sounds. When we ranked the daily returns from those 252 days, we found that the entire return was realized in only 21 days throughout the year. The returns on the remaining 231 trading days during the year sum to 0%. This suggests that for an investor to match the return of the SPY by day trading, he would have had to make the correct call to be in the market on precisely those 21 days—and only those days—out of 252 possible investing days. Of 252 days in the year, 21 is a very slim 8% of the total. The fact is neither you nor Peloton is good enough at guessing the direction of the market on any given day to overcome those odds.

What about the longer-term timing calls? From 2009 through 2013, we had numerous conversations with investors voicing their inclination to “wait until things get better” before getting back into the market. The challenge with that approach is that “things” may never feel better.  If we go back to the depths of the financial crisis, to November 3, 2008, the exchange-traded fund SPY was priced at $90.09. Below are the closing prices for SPY on each of the first trading days of November during the years 2009-2013 and the respective percent price returns from the prior year:

December 2013 Chart

Cumulatively, the SPY is up 100.91% in the 5 years ending November 1, 2013. It’s certainly true that November 3, 2008, was nearing a spectacular low, unbeknownst to anyone at the time. From November 1, 2007, when SPY stood at $148.66, the index plunged -39.4%. SPY didn’t actually get back the 11/3/2008 price until January 22, 2013—4 years and 3 months later.

We’re not trying to cherry-pick by using favorable dates. The point isn’t that if you had only waited to invest until the dark days of 2008, you would’ve enjoyed handsome returns. The point is that even if you made the right call to get out of the market prior to 2008, if you were waiting until “things got better” to get back in, you may never have felt confident enough to do so.

The year 2009 was marked by widespread fear that the U.S. would nationalize the banking system, adopt “socialized medicine,” and plunged inescapably into financial distress after the record $787 billion deficit spending stimulus. In 2010, BP’s Deepwater Horizon rig exploded, killing 11 people and launching the first of 3 consecutive summer stock market swoons. Then 2011 brought us confidence-shaking events like the Syrian uprising, Occupy Wall Street, a debt crisis which saw U.S. Treasury bonds downgraded for the first time, and the Japanese Tsunami—the last of which caused a major U.S. trading partner’s economy to grind to a halt. In 2012, we only had to contend with Hurricanes Isaac and Sandy, the attack on the U.S. consulate in Benghazi, and an increasingly hostile political environment in Washington, D.C. And, in 2013, we learned that the NSA has been spying on us and our allies, and then the Federal government shut down in October. And, through most of these years, another major trading partner—Europe—couldn’t seem to get its house in order and enjoy economic growth at all.

The point is this: when you’re putting money at risk, it never feels like a particularly good time to chance losing it! 

Yet, despite the fact that assuming financial risk is always a bit nauseating, it tends to pay off: S&P 500 earnings rose 24% from $82.54 in 2007 to $102.47 in 2012.

Markets As Prognosticators

Investors speak commonly of “the market.” As we’ve written before, though, there really isn’t one market. Despite the prevalence of the S&P 500 and the Dow Jones Industrial Average, there are actually numerous stock market indices. But, more fundamentally, each public security that changes hands is, in itself, the instrument of its own market. Some of these markets are very efficient—meaning that each bit of good and bad news is reflected correctly and quickly in the stock price—and some are very inefficient.

The prices of securities, whether traded in very efficient or inefficient markets, capture information about the future prospects of the underlying companies. Indices, in turn, capture the collective prospects of the composite companies. In the case of the S&P 500, this suggests that the weighted average prospects of nearly 500 large companies are expressed as a single price. That is a lot of information in a single number!

The concept of markets as discounting mechanisms is very difficult for many investors to understand.” — Peloton CIO, Matt Bradley

It’s no surprise, then, that stock market indices are not lagging economic indicators—confirmers of how things went—but among the surest of any leading economic indicator. Any investor deciding at a given point in time whether the S&P 500 is over- or undervalued—the primary posture of the market timer—is espousing the belief that he is a more efficient prognosticator than the millions of sophisticated and novice participants who are constantly analyzing and assimilating thousands of pieces of information. That just isn’t a tenable position.

On the other hand, we do believe that in market economies, where the laws of economic profit and loss supersede political will and where financial systems are generally stable, shrewd investing compounds wealth. By this we mean that there is good reason to believe that, when owning stocks over a sufficiently long time horizon, investors will continue to be rewarded with capital appreciation.

When Timing Makes Sense

Though we don’t believe that individuals can outsmart the market indices, we do believe that two other types of disciplined timing can add value for investors.

First, if each stock price reflects publicly available information about the company in varying degrees, then it stands to reason that the more quickly accurate information flows to the purchasers and sellers of the stock, the closer the stock’s price will be to fair value. Generally, large companies with broad public followings and which are each covered by numerous professional investment analysts tend to have fairly efficient prices. Investing only in the largest public companies might diminish the ability to identify grossly undervalued stocks, but there may be other reasons to own them (e.g., dividends). At Peloton, we invest in a combination of large companies and mid-sized companies, in part because we believe this increases our opportunities for competitive out-performance.

It also makes sense to align portfolio asset allocations with investment time horizons. We’ve written before that different investments satisfy different financial needs: stocks are engines of growth; bonds provide reliable income; and money market instruments provide liquidity for short-term needs. Perhaps the easiest example is to imagine the 10 years leading up to retirement.  When you stop earning a wage, you begin to look to your investment portfolio to make up part of the lost income and cash flow. Through your working years, you needed only capital appreciation (growth) from your portfolio. But, as you approach the point where you need to spend portions of your accumulated wealth, your allocation should gradually begin to reflect this anticipated shift. In this sense, timing portfolio allocations around the future expected uses of the money makes a great deal of sense.

Full Steam Ahead

We advise investors to decide how much of their wealth they need to have invested, and then to commit to staying the course. This approach has served clients well because it allows the individual investor’s own circumstances to drive the investment decision—just as it should.  We work with investors to begin transitioning from an allocation that satisfies a growth-only need to one that satisfies growth, income, and liquidity needs.

Market timing doesn’t work: the odds of ”acting” correctly and repeatedly are so small, and emotions are so strong and detrimental, that it is almost always a long-term losing strategy. However, timing the purchase and sale of individual securities and timing portfolio asset allocation changes do make sense, and we care for clients’ wealth by providing those services at a reasonable cost.