Chicago, Illinois writes…

I’m hearing some pundits say “the Bear is here, get out of the market.” I’m worried. What is your advice?

Many thanks for asking Chicago – we’re getting this question multiple times a day now.  What the above suggests is that you become a ‘market timer.’ Beware the perils of market timing – I cannot possibly stress this enough. 

Any time the market experiences sudden, sharp selling pressures, like we’ve seen over the last few weeks, two things almost always happen: (1) bearish, ‘sell everything’ headlines and stories appear like crazy; and, (2) investors undergo the behavioral process of strongly considering selling their stocks (or, worse, they actually do it).

It’s understandable why these reactions hang around downside volatility like pests. The media knows it’s an easy road to viewership and investors are simply coping with survival instincts – we want (and in some cases, need) to take action to stop the bleeding and “protect” ourselves. 

But, the moment an investor capitulates is the moment that investor becomes a ‘market timer.’ And what has history taught us about even the very ‘best’ market timers? They will get it wrong more often than they will get it right.

So, why do investors choose this path? One reason is that we’re hardwired to abhor losses about twice as much as we relish gains and that natural, emotional imbalance often gets the better of us. Our instinct, as a result, is to prevent more losses and remove uncertainty, which is one of the great ironies of investing in stocks (since that decision almost always leads to our being out of the market for the gains that will likely follow).  

Investors will nevertheless justify a decision to liquidate assets under the presumption that they’ll be able to reinvest again once stocks resume their rise. But, this mindset is flawed for two reasons: the first is that it is statistically improbable, if not impossible, for an investor to get the timing right (no one can ever know with certainty when the market will rise or fall); the second is that buying stocks after they’ve risen substantially is counterintuitive. It would be like having a list of retail items you want for the long-term, but holding onto your cash because you want to wait for those items to get more expensive before you actually buy them. If there is something you want and need for the long-term (such as equity-like returns), often it’s best to buy equities and hang onto them. In the case of stocks, give history the time it needs to repeat itself as it’s done over and over and over again.

The Dangers of Market Timing, Quantified

The perils of market timing have been quantified by Dalbar, a highly regarded financial services research firm. In a study they conducted from 1995-2014, following are the annualized returns by asset class – relative to the average investor:

  • Stocks: +9.9%
  • Bonds: +6.2%
  • Int’l Stocks: +5.0%
  • The Average Investor: +2.5%
  • Inflation: 2.3%

The primary issue the average investor faced? You guessed it – market timing. Investors were switching in and out of funds at inopportune times. Even though we know that stocks managed a 9.9% annualized return with the tech bubble and the 2008 financial crisis, investors often still try to do better or, as is the case with many given current volatility, protect themselves by timing the market. But as Dalbar shows, it’s actually hurting investors. A lot.

The other oft-quoted statistic is the negative impact of being out of the market on the 10 best days. Using returns of the S&P 500 from January 3, 1995 – December 31, 2014, $10,000 invested would have grown to approximately $65,500 (+9.9% annualized). But, here’s what happens to your $10,000 investment when you start missing some of the upside:

  • Missed the 10 best days: $32,665 (+6.1% annualized return)
  • Missed the 20 best days: $20,354 (+3.62%)
  • Missed the 30 best days: $13,446 (+1.49%)

And, it turns negative from there. Some investors might say, yes but what about being out of the market on the worst 10 days? That would also produce a higher total return, however getting that decision right probably means sacrificing most or all of the good days you need to produce a higher return – six of the 10 best days occurred within two weeks of the worst 10 days. It’s arguably much easier to participate in the good days than to avoid the worst days – the stock market rises a lot more than it falls.

Which brings up a great question investors should ask themselves when they’re thinking of jettisoning stocks in response to pronounced volatility and punditry: why am I invested in stocks in the first place?  Most investors would say it’s because they want/need the long-term annualized growth rates that stocks have delivered over long periods of time. Therein lies the kicker: in order to realize that long-term annualized growth rate, you have to stick with stocks through the good times and the bad. After all, without volatility there would be no reason to expect higher long-term gains. Investors assume risk in order to obtain long-term reward.

Bottom Line for Investors

We’re not suggesting blind bullishness is the end-all for investing and that equities are the only option. You should only own equities to the extent you can tolerate the risk/volatility, and to the extent it makes sense relative to your goals. But, for the equity portion of your portfolio, think about why you invest in the first place – you want the long-term equity-like returns that you know stocks have annualized over the last 100 years.

For many investors, long-term returns offered by equities are what is needed to reach financial objectives throughout retirement. How do you get them? Simple – you invest in equities for the long-term. That formula has not changed over history and we do not think it starts now. If your financial objectives have not changed substantially, then your asset allocation probably shouldn’t either. Again, beware the perils of market timing and stay steady as attaining your investment goals could depend on it.

Disclosure

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

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