I often warn about complacency among investors in the S&P 500. Those more knowledgeable about investment history may be especially concerned. On many metrics, the US stock market is very overpriced relative to historical norms.
So some may be asking, “Is it time to bail? Since the market has been delivering unusually high returns and is richly valued, isn’t it smart to sell and wait for the inevitable downturn? I’ll get back in when it’s cheaper and safer!”
A Good Theory Falls Short
This idea, bailing from the stock market when the pricing seems high in order to jump back in after the prices fall, is called market timing. While this strategy seems intuitively obvious, it has been heavily studied and doesn’t work in real life. Even if stock market pricing is indeed way out of whack, which isn’t easy to ascertain, bouts of market exuberance or panic often last many years. And jumping out and in at just approximately the peaks and valleys, not only doesn’t add value, but it will generally lose you money.
Dot-com Bubbles and Busts
One of the bubbliest markets of all time, the “dot-com bubble,” illustrates how difficult it is to time the market profitably.
In the mid-1990s, the emergence of the internet as a viable mainstream technology triggered one of the greatest stock market frenzies of all time. Virtually any fledgling company that was even remotely connected to the internet exploded in value, regardless of the likelihood of it actually becoming a viable business. And the broader stock market, as represented by the S&P 500, rose to levels historically unimaginable.
By late 1997, financial commentators were saying that investment profits driven by triple-digit returns in Internet stocks were unsustainable. But the stock market kept making fools of them, skyrocketing higher and faster than before.
It was only years later, in mid-2000, that sentiments shifted and reality returned. From the peak, internet stocks crashed by 90 percent, and the broader market fell with it. See the chart of $10,000 invested in the S&P 500 during that turbulent decade.
Surely this quintessential financial bubble’s expansion, bust, and subsequent recovery should have been an excellent time for market timing, getting out high and buying back low. But unless you had impeccable timing, timing the bubble was a fruitless, or even losing, proposition.
5 Jews, 5 Market Experiences
To illustrate this, I compare four (fictional) market-timing investors to another who simply rode through the decade without any portfolio changes.
Check out the chart below, and then continue on for a discussion on each investor’s journey and results.
Mr. Rider Rides the Waves
“Mr. Rider” simply stayed invested in the market via a diversified S&P 500 index fund for the entire period from 1995–2004.
He earned an annualized compound return of 12.07% (including reinvested dividends, i.e., the total return). By ignoring the ups and downs and just riding along, his $10,000 investment increased to $31,256, though it was down from a peak of over $36,000 in mid-1999. It was not easy to control his FOMO and FOLO fears during this roller coaster ride, but he was well rewarded for staying the course.
Impeccable Crushes Rider
But this solid return pales in comparison with his buddy’s, “Mr. Impeccable’s” 17.48% return, whose pot grew to $50,097 throughout the wild journey!
Exhibiting prescient market timing, he was out of the market for ALL three down years (2000, 2001, 2002) and captured ALL the remaining seven up years. This perfection was very profitable for Mr. Impeccable and, following suit, is definitely very tempting.
If you CAN market time correctly, you will indeed end up with far more money than just riding along. The problem is it’s borderline impossible to know precisely when to get out and then back in, as noted, the market looked frothy for years before the peak.
Mr. Medium Gets Minimal Gain
Let’s say another market-timing investor, Mr. Medium, followed Mr. Impeccable’s general thought process, but got out of the bubbly market a year before the peak and then reentered a year before it had bottomed out (i.e., he was in cash for 1999, 2000, and 2001).
Even though Mr. Medium rode the market for six of the seven up years AND avoided two of the three down years, his net benefit over Mr. Rider was minimal! Being a solid-level market timer provided just a slight advantage, of about $1,000, over doing nothing (12.42% vs. Mr. Rider’s 12.07%).
(And if Mr. Medium held his investments in taxable accounts, his net gain was likely wiped out. Admittedly, he probably earned some interest on his accounts during the years he was out of the market. These two counter-balanced points are relevant for all the market timers in the article. )
Missing the oomph of just 1999 and then getting hit by 2002 leaves Mr. Medium virtually equal to Mr. Rider, despite his being generally correct with his timing. He may have benefited from a bit more peace of mind when his money was in cash, but on the other hand, obsessing over when to get out and back in isn’t relaxing either.
Mr. Chaval al Hazman/ Maneuvering to Less
And ill-timed selling and buying can backfire badly, too. A 3rd market-timer, Mr. Chaval, followed Mr. Medium’s path, avoiding 1999, 2000, and 2001 and then reinvesting for 2002. But unlike Mr. Medium, who rode through and stayed in after 2002’s downturn and benefited from the recovery period, “Mr. Chaval” couldn’t stomach staying in.
Mr. Chaval jumped out in 2003 and did not regain his confidence until 2004, when he rejoined the party. But 2003 turned out to be a phenomenal year. Locking in 2002’s loss, while missing the following year’s growth (on top of foregoing 1999’s great performance), leaves Mr. Chaval’s returns for the decade of 9.62%, significantly less than Mr. Rider’s 12.07% (or just $25,056 vs $31,256).
That’s not a bad return, but he should have just left well enough alone. While it may have seemed logical and prudent to gauge the market’s levels all these years, the pondering and maneuvering left him worse off dollar-wise.
Mr. I Chase Loses His Cool and Money
Our final oiber-chacham example, Mr. I Chase, is sadly the most common among people who do not understand the basics of stock market investing.
Chase, and millions of his peers, at first ignored, perhaps were scared of, the huge returns that the market enjoyed in the first couple of years of the tech boom. But after years of hearing about the big bucks others were making, Mr. Chase finally woke up and invested in 1998.
But after enjoying two years of booming growth and feeling proud of himself for jumping on board the no-brainer train, the market teaches him a harsh lesson. His initial investing euphoria is followed by three years of crushing disappointment.
At that point, he bails out with a loss, deciding never to trust the stock market casino again! His original $10,000 is now down to $9,710. And that is the conviction he will stick to, at least until deep into the exuberance of the next bubble!
What About the Pros?
The data is clear. The ability to time the markets profitably is minimal, EVEN FOR PROFESSIONALS. The mutual fund and hedge fund managers, with their fancy MBAs, CFAs, and PhDs, and despite billions of dollars of research and computing power at their disposal, still cannot market time for the most part.
The overwhelming majority of professional investment managers do not beat the myriad humble “riders” of the S&P 500. (Remember the SPIVA data, which we’ve covered before.)
If market timing were easy, then you would find many mutual funds that beat the market, but consistent market-beaters are very rare.
Sure, there are outliers—a few famous stars who navigated the market’s twists and turns perfectly and consistently. But these gurus are hard to find and generally won’t accept individual investors’ money anyway!
The bulk of the efforts expended by professional money managers like Buffett is on selecting the most favorable individual stocks, not guessing the short-term ebbs and flows of the entire market. That’s how virtually impossible it is.
Market Timing Doesn’t Work
The vast majority of investors are therefore best off designing a well-diversified portfolio of mutual funds and then ignoring it for long periods. While a market Rider can’t match the returns of an Impeccable trader, he does very well against the Medium hopefuls, while far surpassing the Chavals and Chasers. When investing, the simple and easy typically works better!
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