Why Market Timing Is the Wrong Approach for High Net Worth Investors
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Originally Posted On: https://pillarwm.com/why-market-timing-is-the-wrong-approach-for-hnw-investors/
Market Timing: Why It’s the Wrong Approach for High Net Worth Investors
Put simply, high net worth investors have little to gain and much to lose by pursuing a strategy of market timing.
What is market timing? It’s an attempt to predict when the market and its various sectors will go up or down, and to shift investments around to capitalize on growth and avoid losses.
Bloomberg recently reported what sounded like a breakthrough of epic proportions, declaring that “The question of when to enter and exit stock trades has been answered.” That’s quite a proclamation. The question of when to move on stock trades has been discussed for decades, mostly by purported experts actively trying to outperform the market.
And history hasn’t shown their efforts to be very prosperous. The great majority (over 90%) of market timers end up underperforming the benchmarks they set out to beat when you track their performance over longer periods of time, like 10 or 15 years.
By that data, the conclusion seems obvious: Market timing doesn’t work for the vast majority of professional investors, let alone individual ones, and isn’t a viable strategy if your goal is to achieve the highest level of financial security coupled with the best investment performance.
With market timing, your performance will likely be worse, and your security under greater threat.
The Bloomberg article discusses data from a Goldman Sachs study that determined the five days before earnings day were the best days to buy, and that four to six days after reported earnings were the best days to sell.
So, there you have it. Market timing is apparently that simple. Their conclusions came from studying data from within the last ten years. You’ll see why that matters a bit later.
Let’s see what the investors using this strategy say after 15 years, and after the next recession hits.
In contrast, let’s consider what some other sources that look at broader historical data have to say about market timing.
Market Timing Leads to Underperformance
Forbes reported on a study from Dalbar that examined investment performance over a 20-year period. They found that “investors in equity funds have lagged the S&P 500 benchmark by an average of 4.66% per year,” and that “part of this outcome is due to poor timing decisions.”
4.66% – per year.
As an affluent investor, you have to think about how much money that represents. You must depart from the mindset that focuses on how your portfolio is doing each year. That information matters to some degree, but 20-year time periods give you a better picture of your financial health and security.
If you have $5 million invested, and you’re underperforming by 4.66% each year, you’ll lose $233,000 just the first year alone. Each year after that, your losses magnify because the value of your portfolio increases. Over 20 years, you’ll have lost millions in underperformance due to market timing, according to the Dalbar study.
Market Timing Is Often Based on Fantasy
The same Forbes article says, “Our brains can often read meaning into things when there’s no meaning to be had. In fact, psychologists even have a word for seeing patterns that aren’t there – apophenia.”
Much of market timing comes down to this – the search for patterns that may or may not actually be there. One reason this happens is because studies into market timing – such as the Goldman Sachs one – analyze periods of time too small to draw valid conclusions. In contrast, most studies showing market timing to be a failed strategy span decades.
Sure, patterns may emerge if you study data from just a few years, in part because there are real driving forces behind a particular market surge or bull market, as well as recessions and bear markets. In each individual case, you might find patterns. But will those same patterns still be in effect ten years later when the market takes its next big swing? Are these patterns on which to build an investment strategy, or were they just observations of what may have been happening in that time period?
And are these patterns causing anything, or are they just random correlations? Causation vs correlation isn’t something you hear market timing enthusiasts talk about too often.
Forbes reveals that the market increased two thirds of the years between 1871 and 2015. That speaks to the danger of market timing, because if you’re not in the market while it’s gaining, you’re missing out on the growth.
This is called opportunity cost.
Market Timing Costs You Opportunities to Gain
The only reason you might miss the top 10 or 20 performing months is if you’re out of the market. And the only reason to be out of the market is if you’re trying to time it. If you just stay in, you hit all the top performing months. So how did that $1000 turn out?
An untouched portfolio beginning in 1988 would be worth $21,106 in 2017, 30 years later. In contrast, missing just 10 top performing months (out of 360) would have resulted in only $8487. Missing the top 20 months? You’re down to $4059.
The numbers are similarly staggering for portfolios started in 1998 and 2008.
In trying to time the market, you will inevitably miss out on top performing days and months. Thus, your portfolio will not grow as much as it would have. Will the few wins you amass be enough to overcome all these opportunity costs?
This opportunity cost often gets lost in the debate about whether to stay in the market during a downturn. We worry about losing money when the market is going down. But you should be just as worried about losing money when it’s going up.
Opportunity cost is harder to spot because your portfolio will still be gaining in value, so you’ll have no idea that it could have been gaining two or three times as much if you weren’t hobbling yourself with a market timing strategy.
More Arguments Against Market Timing
20somethingfinance says simply, “You cannot accurately predict when the market will go up and when it will decline. Or, by how much.”
That added piece about ‘how much’ matters. It’s not just about whether the market goes up or down, but by how much. And, we might add, for how long. Many market losses, even large ones of over 10%, often correct themselves in a matter of months. Just by staying put, you recover all your losses.
But the size of the gains and losses matters too. If you sell a stock and make a profit, you feel good about it. But it’s just as likely that holding on to that stock another six months would have generated an even larger profit. Or that your gains are comparable to what you would have earned with much less trading activity.
In other words, just because you made money timing the market doesn’t mean your strategy worked.
One retired financial advisor sums up his thoughts on market timing like this:
“Nearly half a century of working with investors has taught me this: Many people who try buy and hold succeed, while most of those who try timing (particularly those who do it themselves) fail.”
Half a century.
Again, that’s a time period worth paying attention to. Not a study like the one in the Bloomberg article proclaiming they’ve found the answer to how to time the market. That study only looked at less than a decade of data – all of it occurring during one prolonged bull market. Not a valid statistical sample.
The Other Costs of Market Timing
What market timing proponents seldom acknowledge are the additional costs associated with this style of investing.
Constant trading of equities and mutual funds incurs commissions and higher taxes. Why? Because holding equities for less than a year triggers short term capital gains taxes, which for high net worth investors get taxed at the same rates as your income, currently 37% (but easily raised depending on the politics of the moment).
In contrast, holding equities for more than a year reverts your gains to long term capital gains taxes, which currently stand at 20% for high net worth investors.
Supposing you were able to earn higher performance with market timing, you would need to earn enough to eclipse these nearly doubled tax rates, as well as the commissions you’ll be paying. As we like to say, 10% doesn’t mean 10%. Minus short term capital gains taxes and commissions, 10% looks more like 6%.
Can you outperform the market by over 4% using market timing? Do you know of any financial advisors, big banks, discount brokers, or money managers who can?
A Better Approach than Market Timing
Pillar uses an investment approach we call strategic management. It’s not active, which is what market timing relies on. It’s not passive, in that we don’t just park your money in indexes and forget about it.
The best investment approach – one that truly maximizes performance but without the undue risk of market timing – is one that balances your long term financial security with your need to earn the best possible growth.
For instance, you don’t want to miss out on opportunity costs. But you also don’t want to try so hard to capitalize on every opportunity that you search for every possible scenario where you can buy low and ride the wave. That’s a risky (and stressful!) approach to financial planning.
Strategic management aims to earn you the best possible performance while measuring any potential decisions against your long term financial health. It’s a cost-minimizing, performance-maximizing approach to investing. The analogy for this is like a plane flying on a long flight across the ocean.
You don’t make drastic changes to your flight plan all the time. You make small adjustments, incremental changes, as the wind patterns shift. As you get closer to the destination, you fine tune your trajectory so you don’t overshoot the target, until you land safely on the runway.
It’s a strategy of incremental adjustment, founded on a customized plan, based on your specific life situation and your personal financial needs, both short term and long term.
It’s the safest and best investment strategy for high net worth individuals and families.