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Time in the Market vs. Timing the Market

This is a lengthy blog that argues that sticking with your investment plan and remaining invested in the stock market can generate higher returns than trying to time the market and getting it wrong. The first two parts of this blog were written in early 2008, the last part was written in early 2011. We believe that the underlying argument still holds true – trying to time the base of a stock market trough is difficult, and it seems that long-term investors are better served by remaining invested. There are two dangers. One is that you may sell at the bottom.

The other is that, having sold, you wait too long to reinvest. Missing the first year of a market recovery (while waiting for the ‘second leg’ of decline or a pull-back before buying) is very costly to returns.

The articles were written by myself as part of a team of analysts providing research to Blue Sky Asset Management (run by James Chu, Chris Taylor and Mark Dickson).

Observer – 03 March 2008

The FTSE All-Share tumble of over 9% year to date and near 20% drop from last summer's peak will be leaving many investors wishing that they had exited at the peak and were sitting on cash, ready to pounce at the lows (when the lows are made that is...). The problem with this is that identifying the precise turning points of markets is difficult work, most often best done in hindsight.

The argument between 'Timing the Market' and 'Time in the Market' strikes at the heart of efficient market theory and whether or not active fund managers can add value to investments. The case put forward by many fund managers is that investment money has to be 'in the market' in order to take advantage of the best opportunities to buy. The risk is that by trying to 'Time' the market, investors can miss out the best months which can have a disproportionate effect on their returns.

A widely cited study based on the US S&P 500 suggests that in a long cycle example, 1976 to 2005, the effect of missing the 10 best monthly and the 20 best monthly returns would be truly disastrous. In this example, the 1976 to 2005 'buy and hold' returns were around $36,000 based on a $1000 initial investment. The effect of missing out the 10 best months in the near 30-year period was that the returns were reduced to just below $13,000. The impact of missing out the 20 best months was to see the returns reduced to below $6,000. (source: Axa). They have updated their study since 2008 and now cite a study on European shares as well. The S&P 500 research has been updated by other companies as well and a piece by Bank of America shows astounding results since 1930 of missing the best 10 days every decade.

While there are plenty of caveats to this, for example, past performance is not an indication of future results and the 'survivor bias' of the S&P 500 index makes this study impractical for individual shares, there is something to be said for the idea that missing the boat is costly. As the charts below show, the monthly S&P 500 looks to be a slow grind higher in the 1970's and 1980's, followed by a sharp rally in the 1990's, a collapse at the turn of the century followed by new highs which ended in the high forming last year. The 1980's to late 1990's rally 'looks' like a straight line up, but the monthly return chart shows that for the most part, monthly returns were mixed. Which means that if you remove the best positive 'outliers', the knock on effect for the total period return will in fact make the returns pretty mediocre. Next week's Blue Sky Observer will examine the effect of Time in the Markets on the FTSE All Share....

Observer - 13 March 2008

The FTSE All-Share continued to tumble into March, with over 10% knocked off the index so far this year and a decline of over 20% from the peak registered. Investors are still focusing on the negatives - US and global credit markets remain in turmoil and rate cuts by the US Federal Reserve and the Bank of England have not bolstered shares as much as many had hoped they would. The 'bright sparks' in the market sectors, like Mining, have succumbed to selling pressure recently as the adage of a 'falling tide drags down all boats' proves true.

As mentioned in recent weeks, the temptation for many investors will be to try and wait out the selling pressures and then step in on the ride up. While timing the market is tempting, the long-term studies from major US and European fund houses highlights the potential perils of missing out on the best 10 months or 20 months of returns (see the previous two weeks of the Observer for details). For the FTSE All Share, the charts below show the long index (monthly close) and also highlight the benefits of 'staying in the markets' for many investors in the past (bar charts at the bottom). The 1987 monthly closing peak to trough tumble shed 34% of the value in the index. The 2000 to 2003 peak to trough (monthly close) pullback saw an erosion of 44% of the value of the index. The 5yr. return from the trough to the peak (monthly close, 1987 to 2000) posted returns of over 50%, while the 2003-2007 rally from trough to peak saw a return of over 70%.

The 1974 to 1987 returns are truly outstanding, but may be difficult to replicate as the change in market conditions and the structural reform in the economy were very strong catalysts. The 1987 and 2003 cycles are probably closer to the 'norm' now, and provide a guide to what may happen once the market bases. The critical concept here is that while the markets always look quite bearish on the way down, longer term investors have, in the past, seen the All Share index recoup the losses and then some within 5 years, as 'time in the markets' helps investors to weather the downdrafts, and benefit from longer term bull trends. Missing the trough month can be expensive for those trying to time the markets - as measuring the 4yr. returns from 1yr. after the trough shows in the charts below. The table on p.2 highlights the dates of the monthly peaks/troughs and the relevant returns.

Observer - Time In The Markets....Two years after the trough 21 March 2011

The three-year anniversary of the publication of the 'Time in the Markets' report is at hand, with recent data underlining the risks of missing key investment opportunities by attempting to 'time' the markets.

When the Blue Sky Observer 'Time in the Markets - Not Timing the Markets' was published three years ago (13 March 2008) the FTSE All-Share had fallen nearly 20% from it's 2007 peak. Whilst 'Time in the Markets' is not a new theme, the Observer took the research in a new direction. The usual concept of ‘Time in the Markets’ highlights that investors who miss '10 key days in 10 years' or '20 key days in 20 years' (which, to be fair, can be pretty random - nobody pokes you in the ribs and says 'pssst, this is the low, buy now!') can wind up missing all or most of the subsequent rally in the equity market, which is pretty scary. But, it is not realistic. Retail investors though mostly are not 'traders', they don't miss random days. When 'upset' by market events or lacking confidence in current events, retail investors run for cover, sit on the market sidelines, and miss 'blocks of time'... possibly entire market cycles, but not 'random days'. The Observer therefore chose to analyze the impact of investors being out of the market for 12 months after the last 3 bear market periods - and the results were startling, in terms of highlighting the adverse effect on long term performance.

The bottom line was that since 1972, waiting for one year after the market troughed to step back into the market would reduce the investment returns over the next four years by anything from 75% to near 50%.

5 year returns measured from the 1974 low (chart on top at right) were nearly 250%, while the 4 year returns measured one year after the trough barely came up to 50% - waiting a year cost nearly 200%.

The 1987-2000 bull move illustrates the same point as the 53% return over a 5-year period following the trough in the All Share is double the return achieved for those waiting one year after the trough was set (26%).

The same holds true in the 2003 to 2007 bull move, as 5 year returns of 86% were achieved from the trough of 2003, while waiting one year after the low was posted knocked the returns down to 32%.

What about now? It seems clear that the market trough was set in February 2009. The table below (p.2) shows that the month/month close 1-year return of 41.82% is better than the two previous cycles, as is the 63.44% 'low to high' return on the 1-year study. Now that the market is two years past the trough the real effect of waiting a year, in an attempt to 'time the markets' as opposed to waiting out the bad times in an effort for 'time in the markets' to work for you can be measured. The month/month returns for those remaining in the markets is running at 60.98%, while the month/month returns for those who came into the market 1-year after the trough is 13.51%, a significant difference. The 'low to high' returns are 80.17% and 11.27%, respectively. This underlines the effect of 'Time in the Markets' as missing the critical rally after the trough is expensive. Two years after the trough and the 'gap' in returns is becoming clear, this is expected to continue over the next few years and should be kept in mind during the next bear cycle (and there will be one - in time) as remaining invested appears to make a critical difference in the following bull cycle.

And finally – the updated table of returns 5 years after the 2009 stock market trough. Five years after the trough the FTSE All-Share index was up 102.5%. If you had waited one year after the trough to step back into the market your return four years later would have been 29.9%. Time in the market indeed.

Gerry Celaya

Chief Strategist


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