As we approach the end of summer in 2020 with the S&P 500 near record highs amidst a global pandemic the likes of which haven’t been seen in at least a century, we thought it would be an interesting and insightful time to review the importance of sticking to your long term investment plan. In a year packed with fear and anxiety, whether from financial markets, health risks, employment, or any number of other oddities this year, there were a lot of reasons out there for irrational behavior. As the pandemic struck, grocery stores were overwhelmed. Shelves were ravaged as masks, cleaning supplies and essential items were swept up by the masses. People were buying one to two months’ worth of goods per trip even when instructed by authorities that the shelves would stay stocked if everyone proceeded as normal. But these were not “normal times”.
The same irrational behavior in the grocery store permeated financial markets. As investors panicked, many pulled all their chips off the table driving the stock market down 34% from February 19th to March 23rd. Despite the conventional wisdom to “be greedy when others are fearful, and fearful when others are greedy”, many investors continued to sell more and more assets as prices fell further and further down. Panic had set in.
Yet, we can see from looking at the historical data (above) that large intra-year declines are not uncommon. While this pandemic is truly a “once in a lifetime event”, many events affecting financial markets are deemed to be so as well; (think Global Financial Crisis 2008; Dot-com Bubble 2000 – 2002; Flash Crash 1987). We can see from the chart above that despite frequent intra-year declines, markets tend to post positive results during most years. In other words, it pays to say invested over time.
So Why Do Some Investors Attempt to Market Time?
It is widely accepted in behavioral finance that people are wired to be poor investors. We are inclined to make decisions based on gut feeling, a primitive brain response, rather than cognitive reasoning. This gut feeling is driven by the same part of the brain that signals a fight or flight response when faced with danger. In investing, our brains are triggered by large price movements in the opposite fashion as they should be. Large declines, for example, induce fear into our thinking. Instead of thinking rationally (lower prices = cheaper assets = more value) we have a trigger in our brain that senses fear and is then inclined to act on that fear by selling securities at precisely the wrong time. The opposite is in fact true when markets run up. The “fear of missing out” trigger pushes investors to make rash decisions to buy stock despite the prices they may be paying.
Other investors may be inclined to market time under the effects of what is knowns as “certainty bias”. Certainty bias means that we take something as a fact, when it is just a hunch. “The market has to go down further” was a common one we heard during April of this year. In fact, it is very difficult to predict market movements over short periods of time. The chart below highlights what is known as the time volatility of returns. As we can see in the boxed area, markets tend to go up over time, but the variability of a single years returns (left) is quite wide. As we increase the length of time over which we are analyzing the returns (move to the right), the likelihood of a positive turn gets higher and higher. Again, we can see that it pays to stay invested and might cost us if we play the market timing game.
Why is Market Timing so Detrimental?
By allowing emotional factors to drive investment decisions, investors who do not stick to their plan can find themselves in precarious situations. Looking at the effects of missing out on a certain number of the best days in the market over time does a great job illustrating this point. As we can see below, missing out on just the five best days over a 38-year period (1980 – 2018) resulted in an over 35% reduction in the balance of your capital base. Missing out on the best 50 days resulted in a 91% reduction over the same period.
Another example from JP Morgan, shows annualized asset class returns over time as well as a category for the “average investor”. This average investor category utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. The results show that frequent buying and selling drastically reduce average investor returns to about the rate of long-term inflation through a nasty combination of poor timing, high fees and increased taxes.
At Columbia Pacific, we never encourage market timing. Rather, we promote sticking to your long-term diversified asset allocation targets that your advisor has created to help you achieve your specific goals and objectives. We rebalance the portfolio as markets, spending and specific investment performance drive your actual portfolio values away from those targets at certain times. In periods of market distress, we always encourage you to speak with your advisor about your plan, to understand the course you’re on, and to avoid making drastic decisions that may have irreversible outcomes.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.