STRATEGY SHEET
June 1997
The Risks and Costs
of Market Timing
© Talbot Stevens
When stock markets get near all-time highs, or are extremely volatile, some investors become nervous and wonder if they would be better to pull out of the “over-valued” market until things settle down.
Before you do anything, you may want to consider some of the risks and costs of being a market timer.
Many studies have shown that those who try to get out of stocks before they go down, and back in before they go up, actually end up with lower returns than those who simply “buy and hold”. This is often true even with professional money managers, let alone individual investors.
Realize that to benefit as a market timer, you must be right twice — both on when to get out, and when to get back in. This is very difficult to do consistently.
Attempting to time the market requires a lot of expertise and time. Even if you had the desire to, the amount of time necessary to develop the expertise and constantly monitor the markets is significant and a major cost that is often overlooked.
The simplicity, and “no effort” factors, are two of the big benefits of buying and holding long-term.
There are two fundamental risks in any stock market — being in, and being out. A large portion of market gains occur very quickly over brief periods of time.
A study of the S&P 500, the broad U.S. stock index, from 1980 to 1989, showed that if you simply stayed in the market the entire time, you would have averaged 17.5%.
If you missed just the best 20 days out of the entire decade, your annual return would have decreased to 9.3%. Missing the best 40 days decreased annual returns to 3.9% — less than the return from treasury bills!
Transaction costs are another significant reason not to trade very often. Not only could you face commission costs, but you could also unnecessarily trigger a larger expense — tax due on capital gains.
Multi-billionaire Warren Buffet, considered one of the best money managers ever, claims that his “buy and hold forever” style adds 2 to 3% to his annual returns. This is because tax that would be paid on capital gains if he traded is kept in the fund and allowed to compound, producing a tax-deferral benefit similar to RRSPs.
If you are investing in mutual funds, you have already hired a professional to decide when to buy and sell. Does it make sense to try to override your money manager's expertise?
Markets inevitably do drop, but the impossible questions to answer are when and how long.
It is easier, simpler, less costly, less time consuming, and produces higher returns in the long run to accept the short-term fluctuations, and possibly use temporary drops in the market as opportunities to buy low, or at least, “buy more low”.