Forget about Timing the Market

Can investors realistically time the market to maximize returns, especially in the long term? According to a recent study by Charles Schwab, perfectly timing the market is virtually impossible. The firm’s research showed that most investors are better off investing as soon as possible with a buy-and-hold strategy rather than trying to predict short-term peaks and troughs.

Timing the Market vs. Other Strategies

To produce their new study, researchers at the Schwab Center for Financial Research analyzed the hypothetical 20-year returns of five investment strategies using historical S&P 500 data. Each hypothetical investor received $2,000 each year, which they could invest as they wish.

The investors took the following approach

– Perfect market timing: An investor invested $2,000 each year in the lowest trading venue of the S&P 500.

– Immediate investment: An investor put $2,000 into the S&P 500 on the first day of trading each year.

– Average: Another investor divided $2,000 into 12 equal allocations and invested a portion on the first of each month.

– Poorly timed investment: One investor invested a full $2,000 at the S&P 500’s highest point of the year each year.

– Treasuries: The final investor avoided stocks altogether and instead placed his $2,000 in US Treasury securities each year as a cash proxy and left it there.

Not surprisingly, the study found that perfect timing produced the best returns. However, investing immediately was a close second, and the return generated from perfect timing was only around 8% over 20 years.

In other words, not trying to time the market at all earned 92% as much as timing the market perfectly. In dollar terms, the difference was $10,537, with perfect timing yielding $138,044 and no timing yielding $127,506.

“The best approach for most of us is to create an appropriate plan and take action as soon as possible. It is almost impossible to accurately identify market bottoms on a regular basis,” Schwab wrote in its study. “So realistically, the best action a long-term investor can take, based on our study, is to decide how much exposure to the stock market is appropriate for their goals and risk tolerance and then consider investing as soon as possible, regardless of the current level of the stock market.”

Monthly cost averages also performed well. In contrast, the investor who timed his investments poorly each year beat the one who chose government bonds over stocks, but still lagged significantly behind both the immediate investor and the average investor in dollar cost. Buying only government bonds turned out to be the worst performing strategy of all, and by a wide margin.

Schwab’s analysts concluded that trying to time the market is not an advisable approach for most investors. Without perfect knowledge of future market movements, which no investor has, it is virtually impossible to consistently buy at the market’s lowest point. The potential gains from perfect timing compared to simply investing immediately are relatively small, they said, while the risks of investing at the wrong time are considerably high.

Limitations of the Schwab study

While insightful, Schwab’s study has some limitations. First, it focused exclusively on US large-cap stocks rather than including other asset classes. Most portfolios will diversify beyond the S&P 500 and provide returns that will vary from these results.

Moreover, the analysis is based on back-testing and hypothetical scenarios rather than real investor experiences. Market conditions and individual investment amounts may produce different relative results than Schwab’s assumed models. Conventional investment advice warns against basing decisions solely on hypothetical simulations. But the report still offers valuable insights for those interested in maximizing their portfolio allocation.

So, what is market timing?

Market timing refers to buying and selling investments based on predictions of how prices will fluctuate in the present and future. The aim is to buy assets just before prices rise and sell them just before prices fall. In theory, perfect market timing would allow an investor to consistently buy low and sell high.

However, predicting short-term market movements is extremely difficult in the real world. It also essentially requires the investor to be right twice: they must perfectly time both entry and exit from the market. A small miscalculation in either transaction can have a significant impact on their eventual return.

In fact, previous research from Retirement Researcher found that missing the best single month in the market between 1926 and 2016 would have left a market timing investor with 30% less money than an investor who simply used a buy-and-hold strategy during that time.

Other popular investment strategies

The investment strategies Schwab studied represent popular approaches, but many others may prove suitable for specific situations. For example, here are some popular strategies that investors use:

– Growth investments: This focuses on stocks with appreciation potential. It aims to build wealth over time through rising stock prices.

– Value investing: This searches for underpriced stocks that are trading below their intrinsic value, meaning it looks for mispricing in the market.

– Income investment: This aims to generate income in the present. It favors bonds and stocks with dividends over pure growth potential.

– Index investing: This aims to construct portfolios that match market benchmarks. It aims to capture broad market returns at a low cost, using securities such as ETFs.

Conclusion

The idea of market timing is appealing, but is unlikely to represent a reliable strategy in the real world. For long-term investors saving for retirement or other financial goals, a patient buy-and-hold strategy probably represents the optimal marriage of growth and risk management. In addition, greater diversification across asset classes can provide more balanced returns with less overall risk.

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