In December of 2011, Reuters reported that U.S. equity funds experienced a record net outflow over the last four months of the year which suggests that investors were anxious to get out of the market after a partial recovery from the summer (2010) market collapse. Having failed to see the massive decline coming at the end of July, investors sprang from the market at the first sign of recovery, perhaps thinking that the worst was yet to come. Once again, the market timers missed the mark as the stock market roared ahead over the next six months with record-setting gains and continued its climb for the next two years. As was the case with the steep decline of 2008, and as is typically the case in any market cycle, all those investors accomplished was to lock in their losses and guarantee portfolio underperformance for years to come.
Who could blame anyone for ditching the stock market at the first signs of the financial meltdown in 2008? It looked very bleak to even the most passive investor. But most market declines are not so starkly telegraphed. Most market shifts occur more stealthily, and with little indication as to their long term direction. Yet, many investors hold on to the notion that they can call the shift and make the right move at the right moment.
Although we may read about some investor successes in timing the markets, we have yet to come across anyone with a verifiable record of consistently outperforming the market for any length of time. Morningstar, which probably tracks investment strategies more than most publications, revealed that, in a ten-year period 2000 – 2010, the performance of portfolios engaged in market timing returned 1.5 percent less than the average return of stock mutual funds. Morningstar points out that, in order to have beat the market averages, a market timer would have to make the right move at least seven out of ten times, which only a very small fraction of market timers might be able to do
The Cost of Market Timing
Even for those who manage to time the market correct 50 percent of time, a closer analysis will show that the returns are likely to be offset by the increased costs associated with market timing. These additional investment costs, which can be significant, include:
Opportunity costs: Market timers may be able to miss the worst periods of the market, but, as the research shows, they are more likely to miss the best periods as well. It’s well documented that investors who bailed out during the last one-third of market decline in 2008 also missed the first 70 percent of the market recovery over the next 18 months. In effect they locked in the temporary losses from the 2008 crash for years to come.
Transaction Costs: Mutual fund investors already need to earn returns to be able to offset the fees and expenses which can amount to 3 percent annually. But, moving in and out of funds can increase costs if sales charges or 12(b)1 fees are involved.
Taxes: Successful market timers will incur more capital gains taxes upon the sale of their securities. And, for mutual fund investors, the hidden taxes of high turnover portfolios (paid out of portfolio returns) further erode potential gains.
Is the Potential Gain of Market Timing Ever Worth the Costs?
We are all, inherently, lousy timers. Just think about the last time you were at the DMV and chose the shortest line only to watch crawl to halt, while the longer line churned quickly through; or switching to the fast-moving lane on the freeway only to see long river of red brake lights in front of you. Is it ever worth the extra risk, time or irritation when the potential gain is so small?
If you are not adept at picking stocks or forecasting the direction of the market (and, by-the-way, who really is? ), your best long-term investment strategy is to allocate your assets to reflect your clearly defined objectives and structure your portfolio through diversification in order to capture market returns wherever they occur and minimize your risk through reduced volatility.