The Risk Of Trying To Time The Market

The average investor believes they are a better investor than they truly are, the truth is that most underperform the market. The main culprit driving investor underperformance can be attributed to the inability of removing emotions from decisions. Novice and seasoned investors alike, fall prey to the pitfalls of the market. Be it gambling on a hot stock or trying to sell short during a market pullback. Eased barriers of entry through free trading and fractional shares multiplied the number of trades executed. Executing more moves in the market is by no means correlated with success. Famed economist, Eugene Fama, once said "money is like a bar of soap, the more you handle it the less you'll have". In this article I would like to present a simple case to the opportunity cost of trying to time the market by using the market activity for the S&P 500 total return over the last 5 years.

Historical Return of the S&P

Our sample time period begins on 10/21/15 and runs through 10/20/20 for a total of 1259 trading days giving us 1258 daily returns. The cumulative return for that time period was 88.64% which equates to an annualized return of 13.53%. This was a better than average time period compared to the long-term historical return for the S&P, which hovers around 8-10% depending on the time period you review. Out of the 1258 daily returns 702 were positive, 554 were negative and 2 days were flat. The average return for the positive trading days was 69 bps, the average return for the negative trading days was -74 bps and the average daily return for the entire time period was 6 bps. If you invested $10,000 in the S&P 500 on 10/21/15, your investment would be worth $18,864.37 on 10/20/20. Let's take a look at the implications of missing some of these trading days.

Missing One Day

If you missed just one day during the 1258 days in our study, and if that day happened to be the worst day during the time period, your cumulative return would increase to 114.32%. That results in an additional gain on your $10,000 investment of $2,567.51. Your annualized return would increase from 13.53% to 16.47%, not too shabby for timing one day right. The worst trading day was 3/16/20, the S&P 500 was down 1198 bps. On the flip side, let's assume you failed and skipped the best day instead. Your cumulative return would decrease to 72.44% which would decrease your gain on the $10,000 investment by $1,619.87. Your annualized return would drop from 13.53% to 11.51%, still a respectable return but a significant drop by missing just one day. The best day occurred on 3/24/20, the S&P 500 was up 939 bps.

Missing More Days

If we expand our example to two days, the cumulative returns change to 136.79% for missing the two worst days and 57.74% for missing the two best days. Corresponding annualized returns are 18.82% and 9.54%, respectively. If we extrapolate our process further to five days, the cumulative returns change to 187.13% for missing the worst days and 30.86% for missing the best days. Corresponding annualized returns change to 23.49% and 5.53%, respectively. Five days equates to less than half a percent of the 1258 days analyzed. It's highly unlikely that you would pick, either the five best or five worst days by random luck. In fact, the odds of accurately picking 5 numbers out of 1258 are 1 in 3,125,696,601,186,720. 56% of the 1258 trading days had a positive return, therefore, by random luck, we can assume the likelihood of selecting a positive return day is higher than a negative return day.

Erasing Five Years of Returns

How many of the best days do you think you would need to miss to bring your cumulative return into negative territory? The answer is 13 days, slightly over 1% of all the trading days. By missing these days your cumulative return drops to -4.48%. I won't even attempt to write out the odds of accurately picking 13 out of 1258 days. But those same ridiculous odds apply to accurately identifying the 13 worst days during the last five years. For the average investor, trying to time the market is a losing game.

Granted most seasoned investors do not randomly time the market, those that do follow some strategy that was proven to work historically or one that carries merit in the industry. But even proven methods fail to work consistently, at least those touted across the internet. Nowadays we are inundated with advertisements promising to teach you how to make hundreds of dollars daily by following a trading pattern. The vast majority are scams targeted at selling you an ebook or course that will lead you nowhere. With the odds stacked against you, and yourself being your worst enemy, if you still want to attempt timing the market, try it in a way that reduces your risk exposure.

Take Small Risks

For example, you can dedicate a small portion of your overall portfolio to risky trading, 5-10% depending on your level of comfort. If you anticipate increased uncertainty in the market in the near future, take 5-10% of your portfolio and leave it sitting in cash or a low risk investment such as treasuries or precious metals. The same method can be applied to investing in individual stocks you believe will outperform the broad market. Investing 1-2% of your overall portfolio in an individual stock won't make you rich but it will also prevent you from suffering considerable losses. Recovering from significant losses is very difficult, if you lose 20% on a position you need to gain 25% just to break even. That difference increases exponentially with larger losses, a 30% loss requires a 43% gain, a 50% loss requires a 100% gain, a 75% loss requires a 300% gain.

10% Gamble on Coronavirus Crash

Let me show you an example of taking risk with 10% of your portfolio. Using the data for the S&P 500 total return we have been working with, we know that a $10,000 investment on day 1 would grow to $18,864.37 on the last day for a 88.64% cumulative return or 13.53% annualized return. Let's assume you successfully timed the recent coronavirus market crash. That means selling 10% of your portfolio on February 19, 2020 and redeploying those funds on March 23, 2020. In this case your original investment would be worth $19,827.12, that equates to a cumulative return of 98.27% and an annualized return of 14.67%. If you made the worst possible move, sold 10% of your portfolio on March 23, 2020 and never re-deployed those funds, the value of your original investment would now be $18,191.24. That equates to a cumulative return of 81.91% and an annualized return of 12.71%. In this scenario the best and worst case move your cumulative return by about 10%.

Recommendation

My recommendation to the average investors out there is to stay long, dollar cost average and avoid trying to time the market beyond using marginal percentages of your assets. If you are a young investor, you can take more risk, early losses teach valuable lessons. Time and patience pay off in the market, there are no consecutive 15 year losing periods in the history of the S&P. If you start early in life and ride the ups and downs of the market for 30 to 40 years, adding funds systematically, you're bound to end up with at least average market returns. If you remember, I stated earlier, the long-term historical return for the S&P 500 is in the 8-10% range. If you can achieve that level of return, you're doubling your initial investment every 7.2-9 years, over 30 years that means you would double your money 3-4 times.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.