After stocks have fallen for a time, it’s common for investors to ask themselves whether or not now is a good time to “get out.” Maybe things will get worse, the thinking goes—financial headlines certainly seem ominous. Take some money off the table?
But getting in and out of the market—market timing—doesn’t work the way we assume it does. It’s not consistently possible to get out of stocks before they fall further and get back in before they recover. More often than not, when you sell stocks they rebound unexpectedly and you miss out on gains. Or if prices do go lower, they eventually recover but you don’t get back in in time and stock prices rise to levels above where you sold before you get back in. Either way, you lose.
Let’s look closer at some research on the effectiveness of market timing as an investment strategy.
In a study by Dimensional Fund Advisors, they looked at all periods dating back to before The Great Depression and compared a buy and hold investment in stocks to various market-timing strategies. These entailed getting out of stocks and holding cash (T-Bills) after a stock market decline. Dimensional looked at selling after a -10% decline, -20%, and -30%. They then modeled, for each level of loss, staying out of stocks for 100, 200, or 300 days, which represents our tendency to want to sit on the sidelines “until the dust settles.”
Glance at the numbers below, which represent the annualized returns to all nine market-timing strategies. Not a single strategy earned a higher return than the +9.57% return that came from holding stocks continuously and not selling. Market-timing returns ranged from +5.75% to +8.71% per year, between -3.8% and -0.9% per year lower than just staying the course.
Did any of these market-timing strategies avoid some of the short-term declines on the way to lower long-term returns? Maybe; but if you’re willing to accept a lower long-term return, which is all but assured through market timing, why not just hold some bonds along with stocks in your portfolio? That’s a much more reliable way to minimize portfolio volatility at the expense of lower returns.
Whenever I review this data with investors, invariably someone will complain that this study isn’t realistic in terms of how we actually invest. We don’t sell stocks based on mechanical timing rules, we’re more likely to monitor financial headlines, assess expectations of the near-term future, discuss with other investors, etc. Only after careful consideration, these investors say, would they get out of stocks or get back in. This, they believe, would produce better results. Is that true?
Let’s look at the track record of professional investors who try to buy and sell stocks selectively—including different types of stocks and different investment asset classes—in an effort to outperform buy and hold investing. There is an entire category of mutual funds, run by full-time, experienced portfolio managers, labeled “tactical asset allocation funds.” Comparing their returns to a simple 60/40 mix of stocks and bonds (which has similar long-term volatility to the category), Morningstar found that there is absolutely no sign of market timing skill even amongst the most knowledgeable investors who time the markets for a living.
The table below shows that over every short and long-term period ending late last year, tactical asset allocation mutual funds performed meaningfully worse than the “Balanced” Index. The differences in return were a whopping -2.75% per year over the last decade. Does that number sound familiar? It’s in line with the mid point of the underperformance of market timing from Dimensional’s study above. Apparently there’s no material difference in shortcomings between mechanical market timing and the “smarter” approach pursued by active managers with access to daily insights. Timing the market simply doesn’t work.
For my money though, these studies are not the most persuasive case against selling stocks in difficult times or trying to successfully time the market. Instead, the risk that I miss out on a potential gain is my biggest fear. I know I need all of the returns I can get from stocks to achieve my long-term goals, and I know missing even a year of good results makes it that much more difficult.
At no time am I more worried about missing future gains than after the market has gone down. Why? Evidence shows that whether we’re down -10%, -20%, or -30%, the future looks bright. Stocks don’t continue to decline indefinitely, in fact they tend to rebound and produce future returns that are on average as good or better than what we normally get.
Look at the graphic below, one of my favorites from Dimensional Fund Advisors. What it shows is that the average returns over the following year, three years, or five years after a modest to significant decline is considerable. I look at the one-year numbers and think: If I sold now, and missed a 12% to 18% gain, that’s a real loss. Prices will probably never fall back to where there were before the recovery, and I’ve missed that gain forever. If stocks do continue to head lower in the short run, on the other hand, I’m confident that I’ll eventually get that back—the bigger the decline the greater I expect the recovery to be. I’ll take temporary losses, I just don’t want permanent ones.
I think a better way to look at stock market declines is not a panic situation, where we have to act before it’s too late, but instead as an unpredictable but inevitable part of earning a higher return. We all know the saying “there’s no free lunch,” which in investing means that risk and return are related. In order to deserve a chance to earn a 10% per year long-term return on stocks, we should accept that the path to that return comes with more volatility—more short-term losses and losses that are more severe. If this wasn’t the case, if you could get the same or better return elsewhere, who would bother with stocks?
When we look at the actual year-over-year returns we’ve seen from stocks, and the worst intra-year decline in every year, we see this point vividly. Stock returns are positive in most years, but that doesn’t mean they don’t lose money throughout the year. Looking at the graphic below, we see that the average year in the last two decades saw stocks drop -15% every single year (a range of -37% to -3%).
There’s no indication that a modest decline will even lead to a negative year. In 2001, we saw a peak-to-trough decline of -29%, in 2009 it was -27%, yet the first year saw stocks lose -11%, the other year saw a +28% gain. Same loss, entirely different end result. In 2002, stocks fell -33%, in 2020, they fell -35%; yet 2002 wound up with a loss of -22%, 2020 with a gain of 21%.
These outcomes are as random as they get. You can’t use them to time the markets. All you can do is adopt reasonable expectations—as an investor in stocks you should expect to temporarily lose money every so often. It’s the price of admission. Don’t run from it, accept and try to embrace it.
Now, I concede that there are times when you would want to sell stocks. But those are financial planning reasons—not performance or loss-driven ones. If you need money from your portfolio, let’s say for ongoing retirement income—then selling stocks is reasonable and usually required. That’s a whole different situation.
The rest of the time, when stocks are down, or when they’re at all time highs and you’re just worried they have to go lower, take my advice and tune out the noise. You’re better off adopting and holding a diversified portfolio that makes sense for your goals and not giving up but instead staying disciplined. Watch the video below, it should help reinforce your resolve.
If you have any questions or need a 2nd opinion on your investment plan, or just recognize that this advice is good in practice but in reality very difficult to follow through on by yourself, click here to schedule 15 minutes to have an introductory chat with me.