Stock Market Timing: Why the odds are strongly against it (and why investors should fear missing the upside, not avoiding the downside)

In an ideal world, one would be able to time the markets in order to exit before a given market downturn, wait for the bottom, and swiftly re-invest after the crash, resulting in substantial financial out-performance. However, no academic paper (or rigorous examination of guru records) supports long term success in terms of market timing. An excellent research paper from the Brandes Institute went into a deep statistical dive on why that is, and shows why the odds are so stacked against market timing.

The short summary is it’s far more important, historically and financially, to make sure you are invested during bull markets than it is to avoid the markets during a bear market. Historically, Bull markets outperform nearly 5x in average gains versus average bear market losses.

Yet ironically, most investors stress over bear markets, and the least of their concerns is missing a bull or rising market.

Mathematically and historically, missing a rising market will cost you a lot more overall than successfully avoiding a down market. The following stats from the paper will help drive the point home:

From Dec 1927– Dec 2015 (S&P500 or equivalent):

12 Bear markets (bear market = -20% or larger drawdown), 13 bull markets.

Average Bear Market loss: -35.75%

Average Bull Market gain: +179.8%

In effect, it’s historically 5x more important to be invested for the upside with the stock market index, than to avoid the downside with your investments.

That knowledge alone may help you be more successful longer term as it will make it far easier to avoid the temptation of pulling out of an index fund in order to try and avoid an expected decline, because the real fear should be missing out on the upside.

Now, that doesn’t mean that sitting through a 35% draw-down will be fun (and also emphasizes the need to be careful with margin), but at least knowing that you are playing the odds can help you hang tight. And these numbers don’t include 2016–2018 which had even further upside.

“…a market timing strategist has tremendous natural odds to overcome, and these odds increase geometrically with the length of time and the frequency of the timing interval.” RH Jeffrey

To make things even harder for trying to avoid downturns, and this is where market timing becomes incredibly difficult — the paper found that some of the best positive gains are clustered near some of the largest downturns. Yet, after a downturn is when most people move to cash and then wait until the coast is clear and the market has risen.

Here’s the problem of missing some of the best days, or what the paper terms ‘compression’. Namely, that a large percentage of the markets gains over the long run are ‘compressed’ into a small amount of large upside days.

Consider the time-frame of 1961–2015, or 55 years. The buy and hold annual return was 9.87%.

Yet, if you missed the 81 most positive days during this 55 year period …your return plummets to a meager .03% annualized (!).

In other words, missing only .59%, less than 1% of the total time could take a healthy annualized return and turn it into no better than t-bill returns. Add the cost of transactions on top (commission, spreads) and the picture gets even bleaker.

But what about the ‘experts’? Certainly they are able to time the market?

A study by CXO advisory group collected timing predictions for the market from 2005–2012. A total of 6,582 forecasts for the SP500 from 68 different experts. After reviewing the results and including transactions costs, the Brandes Institute in their paper concludes — “no single market timer was able to make money.” (!)

These results are surprising in one sense, but now that you know about the massive historical out-performance of bull markets vs bear markets, along with the vital importance of not missing the biggest upside days, it’s not as surprising.

An understanding of the results learned from their work will likely help you be a more successful long term investor, and a calmer one as well since you’ll have a better understanding of the mathematical and historical dynamics.

Summary:

A careful review of historical investing results shows that market timing is extremely difficult, due to the following:

1 — The upside of bull markets is historically 5x the average gains vs the average bear market losses. Yet most investors focus and fret over down turn losses, and ignore the bigger risk of missing the upside gains.

2 — Some of the largest gains happen right after the largest downturns. Yet most investors move to cash during downturns, and only return after missing the subsequent large upside gains.

3 —Compression effect — Long term returns are largely driven by a small percentage of large upside days. Missing out on the largest gain days, even only a small percentage, can turn a healthy annualized return of 9.87% into .03% annualized.

The net is that historically speaking, staying invested even during downturns, is what pays off over time. (Important — this refers to stock indexes such as the S&P500…the same is not true for any individual stock which can and do sometimes go to zero :)

It also explains why most investors don’t match the buy and hold returns because missing a small percentage of upside days can dramatically lower the total return.

In fact, for any timing, statistically speaking adding to your investments during a down turn may be the optimal time to add to your long term holdings. Long term meaning 5 plus years.

Note that the paper concludes by emphasizing that asset allocation (i.e. what % of stock index, % of fixed income, etc) is far different than market timing.

Shifts in asset allocation are a whole different aspect of investing and we’ll cover some research on that front in a future article.

Best of luck with your index investments and hopefully the knowledge gained about historical market timing results will help you be both a more relaxed and successful long term investor.

PyTorch, Deep Learning, Object detection, Stock Index investing and long term compounding.

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