The market have been very jittery lately. At one point in the month of January the market was up over 4% in a matter of days. Over the last 2 -3 months it has dropped about 10% from that point. It’s enough to make anyone jittery about stock market investing, but does that mean we should start Market Timing and pull out?
If you have been reading this blog for any time you know the answer is no, it is not time to practice market timing. But today I’m going to present that concept in a bit of a different way. Before we start, to give credit where it is due, all calculations on return from here on out were done using a S&P return calculator and assume dividends are reinvested. All returns are adjusted for inflation.
What would happen if you used market timing to Invest in October 2007?
So imagine it’s October of 2007 and you just received a lump sum of cash. You are one month before the financial crisis begins. The great recession is about to costs millions their jobs and their assets. This of course is all unbeknownst to you so you dump the whole sum into the S&P 500. This lump sum was enough to allow you to retire while starting from 0 net worth, i.e you had no other money. Now imagine you invested all that money into the stock market in 2007 with a plan to let it ride and eventually retire on December 2017. What would have happened to your money?
Well as of December 2017 if you did not touch that money at all it would be worth 80% more now. Think about that for a second. Just ten years later you have 80% more money without ever putting in another dime. Sure with better timing you’d have way more, but 80% is still better than a hot stick in the eye.
What would happen if you used market timing to Invest in April 2000?
Let’s make things a bit worse by backing up in time a bit to April of 2000. We’re a month before the dot com bubble burst. Stocks like Pets.com are all the rage and everyone wants a piece of the internet, not unlike Bitcoin today. Valuations and prices are sky high, only to drop precipitously over the next few years. If you had again received a lump sum and dumped it all into the market what would have happened? Well, by 2017 it would be worth 120% more. In fact, in roughly 16 years, or in 2016, the funds would be worth more than double their original value. It did take longer as the market had a period of about a decade with 0 return, known as the lost decade. But ultimately you would still be doing well after about a decade.
What would happen if you used market timing to invest at the worst point in history?
This is the second worst example in history and yet just 16 years later the market has doubled your investment. But what if you invested during the single worst time in the history of the stock market. What if you put all your funds in on September 1929. A month before the biggest and longest market crash in US history. Well, I have to be honest with you, it would not be pretty. If you were unlucky enough to invest everything you had in that one month, and nothing anywhere else, after 2 decades you’d be back in the green at 8.57% return. It would take you 4 more years, approximately 24 years, to get to double if you left the money sit.
What are the odds of picking the worst day in history?
Heres the thing though. What are the odds of you putting all your funds in during the next September of 1929. Well the S&P 500 was initially formed in 1923. There have been 1128 months since that forming. So the odds of getting all your money in that single month, if you were to take everything in a lump sum was about 0.08%. That’s an astronomically low likelihood, for some there is a higher likelihood that they would receive such a lump sum. Factor in that most people will receive their cash over time and buy stocks over time. Those two factors mean your performance goes up and the likelihood of not doubling your money in less than 16 years is indistinguishable from 0.
We can come to four conclusions from this little mind game.
- I have way too much fun playing with return calculators.
- It’s unlikely that your poor market timing is going to undo you as long as you buy and hold. This is especially true for longer time horizon of a decade plus.
- Most of us invest over time as we make money, which makes these hypotheticals unlikely. For most people only a small portion of their funds would have been contributed during a given month, so the largest impact of such events represents but a small percentage of their funds. Spreading our funds out over many periods instead of one decreases our risk of hitting a 1929 event with everything. Point 3 does brings into question my post on lump sum investing. If you recall, I explained that lump sum investing is a better move over the long run. The thing is, there is not really a incongruence here. You see, lump sum investing is generally the preferable way to invest. The more time your money is in the market the higher your return. This is because in general the market trends up over time. However, dollar cost averaging decreases the volatility of our returns lowering our risk. By spreading out the investment you decrease the proportion of investments that will be beholden to any single month in history. In reality you trade potentially higher return for this decreased risk of potentially extreme negative returns. Now, there are other ways to manage that risk that may result in a better return. Which really gives us a great segway to point 4.
- Liquidity and asset allocation is important in retirement. We’ve shown 3 examples real quick where you would spend from 4 to 20 years in the red. Having enough in retirement out of the stock market to cover at least 5-6 years seems like a must do to cover 90 percent of scenarios. Having an asset allocation of 40% bonds seems like a way more efficient way to manage some of the volatility of a potential Black Swan like the 2008 crash. 40% in bonds again trades return for less volatility, but it does so in a more controlled and efficient manner than dollar cost averaging.
Hindsight is 20-20 when it comes to market timing, Irrational Exuberance.
I would be remiss in not covering the elephant in the room. What if you knew 1929 would happen in September 1929 and sold everything the month before? Wouldn’t your return be way higher? Well yes, but here is the thing, hindsight is 20-20. No one knew or expected any of these crashes beforehand, despite what talking heads may say.
For example, everyone thinks of the dotcom bubble as Irrational Exuberance. They remember the speech that Alan Greenspan gave on Irrational Exuberance before the market crash as an indication people knew it was coming. The problem of course is Greenspan gave that speech in 1996. It took 3 more years for the market to fall. In those 3 years the market returned 91 percent. Over the next ten years the lowest point in the market from 1996 came 6 years later in 2002. At that point you’d still be up 9% from Greenspan’s statement. In fact the only time the market has been below the point of Greenspan’s exuberance comment in the 21 years since the speech, was in the worst few months of the financial depression of 2008. It’s hard to imagine Greenspan had the financial crisis in mind in 1996.
If Alan Greenspan could not market time, how can you?
Now this is Alan Greenspan we’re talking about here. The man who controlled the fed, made monetary policy, had access to every piece of economic data available at the time, and spent his life studying markets. If he can not predict the top of a market neither can you. The conclusion here is quite simple. Forget market timing and continue to put money into the market as soon as possible. Adjust your asset allocation to manage risk, do not use market timing.