27 Oct Say a little prayer and time the market !
If you have watched Limitless, then you might remember Eddie Morra (Bradley Cooper) successfully profiting from trading stocks and currencies thanks to his amazing cerebral capacities unlocked by a mysterious pill. If you have missed it, here is a video for you to enjoy.
I personally love this part of the movie. It represents the common belief that, with the help of complex tools and a deep understanding of financial markets, traders can separate winners from the losers, while perfectly timing entry and exit points. Although Limitless was an excellent movie, there unfortunately exist no magical solutions. It turns out the main factor of performance for a portfolio is its longevity. In other words, the time it is invested in the market.
Time in the market minimizes investment risk
Long-run investing requires patience and discipline, two crucial virtues that are nevertheless hard to follow when it comes to money. How tempting is it to get scared and sell everything when our portfolio starts to plunge and call it “stop-loss”? While it is equally hard to buy when the markets hit rock bottom. The combination of fear and greed makes us our own worst enemies when markets are volatile. We have nevertheless always been following the same belief :
“Time in the market is more important than timing the market”
As we are hearing a lot about how heated the markets are and that sky may fall soon, we wanted to explore some data to validate our belief. Therefore, we revisited some time-tested data points.
The following chart maps the historical performance of the S&P 500, the index of reference for the US stock market, and of the MSCI World as well as the various crisis in the last decade.
The first conclusion we can draw is that the long-term trend for both indices is positive and time to recover from each crisis is short and hard to predict.
The positive impact is further accentuated as we increase the duration of the analysis. An investment of $1 at the beginning of 1980 would be worth $2,248 as of today – not accounting for inflation. As the investment horizon shortens, the story changes.
From this chart, we can easily observe that the range of returns increases significantly as the investment period shortens.
For an investment horizon of 30 years, there are no periods of negative returns since 1970 while the market has seen several major periods of distress, such as Black Monday in 1987 or the financial crisis in 2008 – 2009.
Further, since 1980, for an investment period of 1 year, there is a 22% probability for negative returns. By taking into consideration a longer investment period, 10 years, this reduces to a drastic 7% probability of negative returns.
The table below further elaborates the historic periods of negative returns.
The main conclusion we can draw is that the longer the time in the market, the lesser the risk or probability of loss.
Minimizing risk and maximizing returns are two sides of the same coin.
For the S&P 500, the average 10-year return since the beginning of 1990 is 5.6% per annum.
The chart below shows that, on average, annualized returns are heavily tilted towards the positive side for an investment horizon of 10 years. The historic cumulative probability of negative returns is only 13.6%.
Timing the market: Debunking the “buy high, sell low” myth
Should you invest now? Wait for the market to go down? Has the stock market already hit its bottom? Or is it frothy and waiting for a correction? Being able to answer these questions is the ultimate and rather impossible goal of all investors.
From Nobel Laureate Robert Merton (1981) to Nobel Memorial Prize Winner Paul Samuelson (1994), numerous studies have proven that an investor cannot consistently benefit from market timing. In the context of portfolio management, market timing can quickly become an inefficient and expensive strategy that calls for more luck than skills.
To study the impact of market timing, we examine the impact of missing some days in the stock markets for an investor. To do so, we can compare the annualized loss incurred by investors missing the best days of the market instead of staying fully invested.
Missing only a few days in the stock market can have some drastic consequences on the performance of the whole portfolio. By missing the 30 best days, which is just 1.2% of the total days over the period, the performance of a portfolio would have been decreased by 8.7% per year. The consequences are thus significant.
Market timing is a brilliant concept, in theory. In practice, it often goes wrong. Therefore, we don’t pray and time market entry. Instead, we dollar-cost average all investments, irrespective of portfolio size.
Do watch for our next blog post on the impact of dollar cost averaging over various market cycles.
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