The Risk of Market Timing

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The harsh reality of the market’s recent tumbles has not stopped traders and investors from attempting to read the future. With large drops late last week, many were calling for a “market bottom”.

Market timing offers a seductive prospect – predict market direction ahead of time and capture only the best-performing days and avoid the worst. The reality is that, trying to forecast which days or weeks will yield good or bad returns is a guessing game that can prove costly for investors.

Large gains often come in quick, unpredictable surges. An investor who misinterprets events may leave the market at the wrong time (i.e. Monday or Tuesday of last week) and miss the surges (Thursday and Friday). Missing only a small fraction of days—especially the best days—can defeat a timer’s strategy.

The above graph tells the story. The graph plots the S&P 500’s annualized compound return since 1970. The green bar (far left) shows what a buy-and-hold investor would have earned in annualized return for the entire period – about 11%. The bars to the right show the returns if an investor had missed a certain number of “best days” in the market. Missing the best 25 trading days would have significantly cut S&P 500 Index annualized compound return. Investors who attempt to predict market drops are just as likely to miss out on strong return periods.

A better strategy is to stay invested in a diversified portfolio though the tough times so that you're in the market to enjoy the eventual good days.