The Continued Flaws of Market Timing: Lessons from the Coronavirus Pandemic
By Sloan Smith, MBA, CAIA, CPWA®
Due to the recent drawdown in the global equity markets, market timing has again become a key discussion point among investors. Since the beginning of the coronavirus pandemic in late February numerous investment firms have provided their forecasts on a variety of topics such as the economy, the stock market, unemployment, the shape of the recovery, etc. Some of their predictions are intriguing, but they prompt investors to ask once again: “Do I need to get out of the market or stay invested?”
Attempting to time the market, which is making buy and sell investment decisions based on predictions of market movements, is a flawed exercise and is not the same as investing. Although human psychology tempts many investors to time the market, it is very difficult to consistently experience success, even among experts. Given the costs and risks associated with market timing, diversifying and rebalancing portfolios while maintaining a long-term outlook is the better course of action.
The Temptation of Hindsight
Market timing’s attractiveness stems from the human desire to detect patterns in security price movements and to avoid the painful losses of down markets. For example, an investor might notice that some technology stocks have performed well not only over the last five years but also during the coronavirus pandemic. The investor may conclude from this observation that this trend should continue, and technology stocks should appreciate over the following year. However, research by Innovest and a myriad of other investment firms has not been able to identify investment firms or professional investors who have consistently linked correct decisions of when to invest in risky assets and when to move to cash and back in again.
Since accurately timing the market’s movements on a consistent basis is impossible even for professional investors, one would expect most nonprofessional investors to avoid the practice. Yet many continue to ignore this lesson. Nobel Prize winning economist Daniel Kahneman shows that on a psychological level, investors tend to overestimate their abilities while underestimating risk and the role that chance plays in investment performance. Called the “overconfidence bias,” this dangerous thinking occurs when a good (or lucky) prediction in the past makes us overconfident that the same success can be repeated consistently.
Overconfidence bias is not the only danger; experiencing losses can also be quite treacherous for market timers seeking to avoid impending downturns. Kahneman’s research has shown that investors tend to experience more regret following losses than satisfaction following gains. This behavior, known as the “loss aversion bias,” leaves investors more apt to sell securities after they have fallen in value and to hesitate before reinvesting. As a result, such investors miss out on the periods of greatest price appreciation.
The Difficulty of Timing the Market and the Potentially Painful Results
While consistently predicting market movements over long periods of time is impossible, investors continually fall into the trap of believing that new market downturns are different and that market timing may make sense. For example, during the beginning of the 2020 coronavirus pandemic from February 19 to March 23, the S&P 500 fell 34%. This event was the fastest drawdown in the S&P 500 since the Great Depression. The coronavirus created panic around the globe, leading to stay-at-home orders, high unemployment, and an abrupt slowdown in the economy. Without a treatment or vaccine in sight, it appeared the global markets would continue to freefall. Many financial experts believed the S&P 500 drawdown would exceed the 57% losses during the Global Financial Crisis of 2008.
It was during this same period that investors started saying, “This time is different” and “I think I need to get out of the market until things look better.” Dean Witter famously said in May of 1932, which was only a few weeks before the end of the worst bear market in U.S. history, that “Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.”
Since the market bottom on March 23, 2020, the S&P 500 rallied by approximately 35% as of June 19, 2020. It appears that the turnaround in the market has been due not only to the actions of the Federal Reserve and U.S. government, but also because of the better-than-expected economic reports since late March. However, if investors had decided to exit the market in March and refused to rebalance their portfolios, then they would have locked in their losses and not have participated in the tremendous equity rally.
Costs and Risks Associated with Market Timing
In addition to the difficulty of predicting market moves, there are significant risks and costs associated with market timing. One significant risk of market timing is missing the best days in the market. A study from Litman Gregory, shown in the chart below, illustrates this issue. Consider the annualized 7.5 % return experienced by those invested in the S&P 500 for the period from 1950 through March 30, 2020. Compare this return to the 6.2% return achieved by an investor who, in attempting to time the market, missed the ten best days during this time period. Even worse, the return experienced by an investor who missed the twenty-five best days would have been an annualized 5.0%. These surprising statistics illustrate the substantial risk of being uninvested and what the $10,000 initial investment would have looked like in each scenario.
Figure 1: (Staying invested versus Missing the best day in the market)[1]
Market timing can also reduce portfolio diversification and increase transaction costs. Investors who significantly alter their portfolios based on market timing signals and refuse to rebalance will typically lose some benefits of diversification. Less diverse portfolios, in turn, will have higher expected volatility and thus lower risk-adjusted returns. Similarly, higher transaction costs and taxes on realized capital gains from additional trading activity erode investment returns.
Conclusion
Famous mutual fund manager Peter Lynch once said "There will always be someone predicting disaster and someone predicting great fortune. At one time or another, each will be closer to correct than the other. But it won't matter to you if you understand this and have invested responsibly. If you have a long-term plan, stick with it." Rather than trying to time the market, developing and sticking to a diversified investment policy and periodically rebalancing over the long run is the recommended time-tested method of generating strong performance. These principles were true during the coronavirus pandemic and will remain during future downturns as well. Market timing is a faulty exercise. It is essential to remain disciplined, composed, and focused on your long-term objectives during times of uncertainty. The success of your portfolio depends on it.
Figure 2: (2020 Performance of S&P 500 as of 6/19/2020)[2]
[1] “Stay the Course: There’s a cost to timing the market”, https://lgam.com/stay-the-course-theres-a-cost-to-timing-the-market/
[2] https://www.macrotrends.net/2488/sp500-10-year-daily-chart