Market Timing

By Stephen Smith

November 26th, 2007

The risk of trying to time the market

Nothing ignites the fear of losing one's hard-earned investments like a violent, short-term stock market correction. For many investors, even those with a long-term time horizon, the natural human reaction to a sudden drop in the stock market is to reduce or liquidate one's exposure with the intention of trying to stem further loss of capital. In reality, temporary stock market declines in the range of 5-10% are not unusual. As a result, short-term moves are inevitable in the long-term upward trajectory of the market.

The cost of missing out

Attempting to move in and out of the market can have a big impact on a portfolio because a significant portion of the market's gains over time have tended to come in concentrated periods. Looking back at the performance of the S&P 500 since 1980, an investor who missed out on only the five best-performing days in the market would have ended up with a portfolio worth roughly 26% less than one that had been fully invested throughout the period. Further, missing just 30 of the best-performing days for the market since 1980 would have reduced the value of a portfolio by about 73%, compared to one that remained fully invested. Some of the best periods to have entered the stock market have been during periods of negative sentiment and market volatility. Since 1926, the best five-year return in the U.S. stock market began in May 1932, in the midst of the Great Depression, when stocks rallied 367%. The next best five-year period, where the stock market rose 267%, began in July 1982 amid an economy in the midst of one of the worst recessions when there were double-digit levels of unemployment and interest rates. Investors might use these lessons from history to remember that staying fully invested can give them an opportunity to fully participate in the market's long-term upward trend. Waiting until the backdrop feels "safe" to make an investment in stocks has historically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.

Since 1926, it has paid to stay invested:

**Three dates determined by best five-year market return subsequent to the month shown. Source: FMRCo (MARE) as of 12/31/2006

Investment implications

Short-term corrections are not uncommon in the history of the stock market. In fact, such periods of sudden turmoil have been normal occurrences in the market's long-term upward trend. Investors face long odds in trying to time the ups and downs of the stock market, and data shows they have historically mistimed their allocations to stocks by increasing their exposure ahead of market downturns and decreasing it just prior to rallies. This mistiming can be costly: missing out on just a handful of the best-performing days in the market may leave investors at a significant performance disadvantage compared to investors who remain fully invested for the long term. Furthermore, hindsight suggests that during some of the most challenging economic backdrops in history, investing in stocks, not fleeing them, has been a prudent decision.