We will probably never admit it, but most of us are lousy timers, and, of course, none of us can predict the future.
How often have you tried to shift your way through stop and go freeway traffic to end up in the slowest lane again?
For investors who try to time the market, the actual costs of underperformance and lost opportunity are invariably greater than the potential benefit.
A case study in the futility of market timing
Peter Lynch, who managed the Fidelity Magellan Fund from 1977 to 1990, is considered one of the greatest investors of all time. It’s difficult to argue that considering his fund’s annual return averaged more than 29% during his tenure there. So, you would think that investors in his fund earned substantial returns during that time. You would be wrong. According to a study by Fidelity Investments, the average investor in the Magellan Fund actually lost money!
While that may be an extreme example, the fact is that average investor returns consistently underperform the average fund. According to Morningstar, the average investor has lagged behind the average fund by one to two percentage points over the last ten years. This “return gap,” which tends to widen during periods of market volatility, is attributed to investor behavior, such as chasing performance and trying to time the market, which are both very costly behavioral mistakes.
The consistent underperformance of market timers
While it’s not impossible, very few investors can time the market with any degree of consistency. According to Morningstar, to do better than the average market timer who underperforms the market by 3%, you would have to call the market direction seven out of ten times correctly. It also means an investor has to make two correct decisions each time – deciding when to exit the market and then when to get back in.
Here are a couple of more factoids that should discourage anyone from trying to time the market:
- According to a study by Dalbar, the 20-year annualized S&P return through 2019 was 9.96%. In comparison, the 20-year annualized return for the average equity mutual fund investor was only 5.04%, a gap of 4.92% due primarily to poor market timing decisions.
- According to Morningstar, investors who stayed in the market for all 5,217 trading days between 1997 and 2017, earned a compound annual return of 7.2%. However, if they missed just the ten best days of stock market returns, they would have gained only 3.5% If they missed the 40 best days during that period, they would have lost 4.5%. The same report reveals that the biggest gains in the market often occur during or immediately following a market correction.
Can the possible gain ever be worth the actual costs of market timing?
Even if you have the good fortune of calling it right, half of the time, experts who have carefully studied the issue point out that the costs of market timing make it difficult to gain any real advantage.
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% of the market recovery over the next 18 months. In effect, they locked in the temporary losses the 2008 crash for years to come.
Transaction Costs: Mutual fund investors already need to be able to offset the fees and expenses, which can amount to up to 3% annually. But, moving in and out of funds can increase costs if sales charges or 12b1 fees are involved.
Taxes: Successful market timers will incur more taxes, effectively lowering their returns.
The difference a good Financial Advisor makes
Why do investors consistently make the mistake of trying to time the market? Emotions, primarily. Fear and greed mostly. However, studies show that investors’ emotions are often triggered when they don’t have a strategy or don’t understand their strategy. When they don’t understand why their money is invested the way it is, they lack the conviction to stick with it. They will abandon the strategy at the first sign of trouble, which invariably leads to underperformance.
The Vanguard Group conducted a study in which it found that a good advisor can improve investment performance by as much as three percentage points annually. That may not seem like much, but if you compare a portfolio that earns 7% annually with one that earns 10%, the outcome over a 10- to 30-year timeframe is astounding.
After just one decade, the difference is over $30,000, but the compounding effect of that extra 3% return is worth more than $1 million after 30 years—a difference that can make or break financial futures. According to Vanguard, the difference lies in the value a quality advisor brings to a client relationship in the form of real-time consultation and coaching clients to stick with their strategy (1.5%); constructing the right asset allocation according to a client’s objectives and risk profile (0.75%); and having the client invest in low-fee options (0.45%).
In addition to helping clients to create a strategy, it’s the advisor’s primary role to help them understand the strategy and then coach them through the turns in the market. The advisor’s role is to instill the patience, discipline, and confidence most investors lack when investing on their own.