With investing, staying invested for the long term (doing nothing) is often better than doing something – here’s why…
All financial markets have good days and bad days. This leads many people to conclude that the key to successful investing is therefore simply to be invested on all the good days and not invested on all the bad days. However, many studies strongly suggest that trying to ‘time the market’ is actually a terrible (and actually costly) strategy for most people.
Markets are pretty unpredictable and driven by a mammoth number of variables, ever-changing global events and, importantly, by emotional and sometimes irrational human beings. Market timing is therefore, to put it mildly, rather difficult. The likelihood of correctly predicting exactly when to be invested to maximise profit on good days and minimise losses on bad days, are… well, minuscule.
I can honestly say that the biggest moves in the market have sometimes come as a complete surprise to me even though I have decades of investing experience and a superior investment track record. It’s amazing to me therefore how many people feel they can time the market – sell before it drops or buy when it’s about to rise. Counterintuitively perhaps, I must say that the most successful investors I have worked with really don’t waste their time staring at equity prices all day nor do they try to gauge where the market might be this week or even this month.
An alternative to reacting to every single market sneeze is to do nothing and think long term in terms of your investments. To us emotionally minded humans, it can sound like a risky and counterintuitive approach. When you see your investments losing money the urge to jump out and sell to limit your losses can be overwhelming. Today I’d like to explain why trying to time the market may actually cost you more than you think!
HOW CAN DOING NOTHING BE A GOOD IDEA?
Academic research tells us that the pain you feel when making a financial loss is twice as strong as the joy of making a gain of equal value, which explains the temptation people have to sell their investments in the hope of avoiding further losses when markets start to fall. Without a crystal ball, it’s difficult to know for certain when markets are going to recover. If you’re uninvested and markets rebound overnight, you could miss out on potentially some of the best days to be invested all year.
But how can we be sure of this? It seems totally counterintuitive to do nothing. You can actually measure the effect of doing nothing versus doing something, by looking at how different your returns would have been in the past. The graph below shows the effect on your overall returns of missing just the best 10 days in the FTSE 100 since 1986 versus staying invested.
HOLDS TRUE EVEN IN AN EXTRAORDINARY YEAR LIKE 2020
For more reasons than I care to recount, 2020 will certainly go down as a year to remember and a year to forget. The long-term investor, however, can reflect on 2020 as a historic “teachable moment” on how counterintuitive market performance can be and how attempting to time the market can be confounding, and even dangerous.
Looking back at the nadir of the S&P 500 on March 23rd, one couldn’t be blamed for considering selling stocks. Those who did were mostly thinking about the four most expensive words in investing: “It’s different this time.” To be fair, 2020 was different in that it’s been over 100 years since we’ve endured a global pandemic. But what was not different was that stock markets tend to overreact in the short term but typically course-correct over the long term in valuing the future value of companies’ cash flows. In fact, if someone were horribly unfortunate and exited at the bottom of the market on March 23rd, they would have missed a 70%+ return from the bottom in just over nine months.
Of course, hindsight is 2020 (no pun intended) but the point is that protecting ourselves from ourselves is paramount when it comes to emotion-driven buying and selling. Too often investors project either irrational fear or over-confidence regarding future returns and in turn, buy or sell before they think “the market” will move higher or lower.
Unfortunately, numerous other industry studies confirm the huge long term damage to returns suffered by those succumbing to the siren’s song of market timing.
One study done every year by the research firm DALBAR Inc. details the 20-year history of the typical investor, the most recent spanning December 31st, 1999 to December 31st, 2019. The critical takeaway is that while the S&P 500 returned an average of 6.06% per year since 1999 (including two harsh bear markets in 2001 and 2008), the average stock investor only realized about 4.25% per year. While 1.81% may seem insignificant, over the course of 20 years the difference in dollars is nothing short of staggering. For reference, starting with a $500,000 portfolio at age 45, this emotion-led gap in returns year after year would compound to an account value of $1.1 million instead of $1.5 million, a shortfall of $400,000. In real life, that could mean extra years of early retirement or not meeting other life goals.
Even more striking is the impact of missing just a fraction of the market’s best days over the course of 20 years as noted by a study published by Charles Schwab in their 2021 Quarterly Chartbook (please see chart below). Using the S&P 500 as a proxy, this study clearly demonstrates the damage inflicted on returns by missing just a few days out of thousands of days over 20 years.
To put this in perspective, an investor who started with $500,000 and missed just 40 of the top days of market returns in 20 years (or about 0.5% of the days) would have missed out on $1.7 million! (Please see table below for additional detail.)
To add insult to injury, the investor would have likely spent endless hours researching their investment thesis and enduring countless sleepless nights trying to “make the call” on both when to get into the market and when to get out.
TIME IN THE MARKET - NOT TIMING THE MARKET
Knowing all this, how does an investor inoculate themselves from themselves? It’s important to remember the following:
- Equities are volatile and investing in them only makes sense over the long term. It makes no sense to put money into the market that you may need to spend in the next couple of years.
- Young people have a huge advantage in that they have many years to grow their assets before they retire. So they should start - however small - as soon as they can.
- I truly believe everyone should educate themselves and really understand what it is that they are buying. Doing your homework and researching what you put your money in is in my opinion a far better way to protect your money.
- Ignore the daily ups and downs, stay invested and think long term. As we have seen, it’s your best bet to maximising your returns. Too few people appreciate the magic of compounding over the years.
- One of the best ways to smooth your portfolio returns is to invest regularly and develop the habit of putting money aside for the future. You will be drip-feeding your money in, effectively investing on an average basis through the short-term market ups and downs.
When investing, your capital is at risk and you may recover less than you initially invested. Past performance is not indicative of future results.