- Accurate market timing would lead to amazing returns, however it’s extremely difficult to actually time the market. I’ll show why.
- As market timing is difficult, I’ll also show what you can do that will allow you to lower your risk and increase your returns.
- Focusing on long term underlying earnings will allow you to outperform the market and significantly outperform the average investor.
The question many investors ask themselves is should they try to time the market.
This is especially important now that many, including myself, keep shouting about how the market is overvalued.
I have also discussed scenarios that imply a 70% downside for the S&P 500. Therefore, I understand your concern and I’ll try to provide a valuable answer to the question of market timing in this article.
The Problem With Selling It All Now
The problem is if you sell all your holdings and remain in cash, you would miss out on any potential future upside, dividends, takeovers at premiums, etc. What investors usually do after selling, is to buy back in at a higher level in fear of missing out on more upside and then find themselves buying right before the drop.
Figure 1: The usual market timing pattern. Source: Franklin Templeton Funds.
The issue with timing the market is that time in the market creates long term returns. If you miss out on just a few of the best days in the market, your long term returns are severely affected. For example, if you hadn’t been invested on October 21, 1987, you would have missed out on a 10% run, which would now result in a loss 10 times larger as the S&P 500 is 10 times higher. On the contrary, missing out on the 20% decline on October 19, 1987 would have saved you a lot of money but to make such a trade profitable, you would have had to have sold just before the drop and buy just before the upside. In this case, selling on October 18, 1987, and buying back in on October 20. This might sound exciting, but I find it impossible to do if you aren’t a professional trader. Even if you are, you would have missed out on a big part of the bull market from 1987 to 2000 as stocks practically only went up.
What’s very interesting is to see how close to each other the best and worst market days are. The most positive S&P 500 day in history was the 13th of October 2008 while the second worst day was the 15th of October of the same year.
Figure 2: Top S&P 500 gains and losses. Source: Wikipedia.
A strategy that would take advantage of such market moves would incur high transaction fees while it’s highly unlikely that you could accurately time such short term market moves.
Now, you’re probably saying: “Sven, this doesn’t help much, first you tell us that the market is overvalued and then that if we sell, our long term returns will probably be lower because we will probably miss out on the best days that will create the highest returns.” Let me now show you a few things that everyone can do.
What You Can Do
If market timing is difficult and probably not something that 99.9% of the population can do, not even Buffett or Ray Dalio do it, what can be done?
Well, there are a few things that can be done. They won’t save you from a market crash, but they can definitely limit the damage and thus increase your average long term returns.
What many often forget is that a difference of a few percentage points in their yearly returns leads to huge differences in portfolio values over a decade or two. For example, $100,000 invested now in the S&P 500 will probably deliver a return of around 5% in the next 20 years as long term returns are correlated to underlying earnings. $100,000 at 5% after 20 years is $265,000.
If you manage to achieve a return of 10% over the same period, which isn’t impossible, your portfolio would be at $672,000 after 20 years, or almost three times the value as with a 5% return. And that’s exactly what every investor can do, focus on lowering risks and increasing yearly returns.
Timing the market is something better to be left to speculators. Here are three things everyone can do to increase long term returns:
- Stay invested: By staying invested, you reap the long term rewards stocks offer, i.e. inflation protection, growth alongside the economy, and dividends. These three things are the essence of investing because long term returns depend on them.
- Add to your portfolio and reinvest: The benefit of constantly adding to your portfolio is that you are ready to buy throughout the cycle, which means that you will also buy at a low market point which is where you will find the highest returns. This is one way to benefit from market timing without the risk of missing out on the positive sum game of stock investing by staying out of the market.
- Invest with no risk: The third thing you can do is to only invest in stocks or other asset classes that offer you your required return at no risk. For example, my required rate of return per year for stocks is at least 20% and I don’t invest in a stock if the return is lower. The no risk part means that in the long term, there is practically no possibility of permanent capital loss as sooner or later, the value of the investment will be recognized. This means that either the actual earnings give a return of above 10%, or that future earnings, or average long term earnings, also lead to high returns. By looking for this, you can really find investments that will enable you to have a portfolio a few times bigger than would be the case if you just follow the market.
Investing is something inherently easy, the only thing to do is find a few investments that offer a long term satisfying returns at low risk. You don’t need many of these, one per year is sufficient to reach amazing returns.
If you allow temporary market swings or the media to influence your investment strategy, you will probably end up like the average investor who achieved returns of 2.3% per year in the last 20 years even though the market returned 7.7%.
Keep reading Investiv Daily as we’re always discussing investing strategies and asset classes that have a high probability of outperforming the market in the long term.