The following is a guest post by Michael A. Gayed, CFA, Chief Investment Strategist, Pension Partners, LLC. We've discussed this line of thinking previously, but I think it's good every now and then to re-stir the pot. ;-)
The post titled Market Timing Doesn't Work. Yes, It Does. No, It Doesn't. Yes, It Does addresses conflicting opinions about the validity of market timing. The big question, however, is WHY it does or doesn't work. To answer this, let's take a look at some actual hard facts about the nature of equity price movements by taking a look at the S&P 500 ETF (Symbol: SPY). Take a look at the chart below (click to enlarge):
What I did here was download the daily price data for the SPY ETF since inception (1993), ranked the daily returns, and came up with different returns patterns based on whether you were in the market in the best or worst performing days. The blue line represents a simple buy and hold strategy (with no market timing). The red line represents what the return would have been if you had timed the market and happened to have missed the 10 best days of performance. The yellow line is the return you would have seen if you had timed the market so perfectly that you were not exposed to the 10 worst days. Finally, the green line shows what would have happened if you had missed the 10 best and 10 worst days of performance.
Here's how the performance ends up:
- Growth of $100,000 from 1/29/1993-8/30/2010
- Buy and Hold: $324,330.15
- 10 Best Days Removed: $156,354.12
- 10 Worst Days Removed: $692,693.90
The difference in performance is enormous. We're talking about timing just 0.2% of the days in the sample period. Think about this for a moment: 10 days account for most of the return! Market timing becomes extremely difficult because the odds are against you – you have to be in the market's best performing days, and out of the market's worst performing ones.
But what is the risk? I argue that the risk is NOT the yellow 10 worst days removed line, i.e., not in outperforming, but in missing the best days. The truth is buy and hold appears to work in an almost lottery type fashion—you have to be in it to win it for those low probability, high impact (Black Swan-ish) days for the compounding effect to really make a difference cumulatively.
What's the takeaway for you?
- Recognize that equity price pops and drops are largely unpredictable, yet account for most of the cumulative return
- Don't over-trade and try to pick up pennies in front of a steamroller since performance is driven by the rare $100 bill trades (10 best days)
- It’s okay to vary your exposure to equities, but do so with a broader asset allocation plan in mind
- Being contrarian is a lot easier said than done—be honest with yourself in terms of what can and can not be accomplished through active trading.