What a ride these past six months have been! Before reaching the mid-point of the calendar, equity investors endured the climb to all-time highs, a harrowing 34% bear market drop and a rapid 44% rebound. To put that experience in context, a typical market cycle plays out over three to five years. Faced with this volatility, some investors resorted to various forms of market timing despite its proven lack of success. After a brief review of the temptations of market timing and its negative impact, we outline actions an investor can take to strengthen their resolve when faced with the urge to time the market.
Equity investors accept the higher level of risk inherent in their pursuit of returns in excess of those available in less risky markets. Although painful in the moment, the drawdowns experienced from February to March and in Q4 2018 are within the range of normal expectations. Why do some investors succumb to the urge to head for the sidelines when markets get challenging? The rationale behind the timing moves often falls into one of the following buckets:
- Actual risk tolerance lower than perceived: Everyone is a risk taker when equity markets are moving higher. Significant drawdowns test whether investors’ willingness to take risk aligns with their ability to do so.
- Taking control: Confronted with the reality that gyrating markets are beyond their control, investors attempt to regain a semblance of it by taking action to move out of the market.
- Protecting cash flow needs: An investor with low or no “liquidity reserves” changes course to stockpile enough cash to meet the next 12 – 24 months of spending needs.
The futility and detrimental impacts of market timing have been well documented. A market timer must consistently be right on both their exit and entry levels to be successful. Most often, they exit too early and enter too late. Investors easily forget that equity markets discount future expectations and respond before we get the data. Mistimed moves into and out of the market can significantly dilute an investor’s long-term gains. For example, a recent study by Dalbar Inc. found a typical U.S. stock mutual funds investor underperformed by nearly 5% per year over the past 30 years through 2019. Assuming an annualized 9% equity market return over the next 30 years, a 5% underperformance on an initial $100,000 investment results in the reduction of an investor’s wealth by over $1.1 million.
Year-to-date returns have been rather mundane in aggregate. Through June 17th, the S&P 500 sports a year-to-date loss of -3.6%. A fact disguised by the six-month roller coaster ride filled with frequent market twists and turns. Almost all investors would struggle to provide a reason such a modest drawdown would warrant a second thought regarding their commitment to equity investing. However, staying committed to your strategy is easier said than done in the face of falling share prices and a parade of negative headlines. How then does an investor fortify themselves against the urge to partake in market timing activities when the inevitable challenging markets arrive? We encourage all investors to take the following actions when putting an investment plan in place:
- Acknowledge the risk associated with equity investing: Volatility is inevitable and expected. Honestly assess your willingness & ability to experience declines.
- Control the controllable: Set an appropriate asset allocation strategy. Assess the potential for declines in both percent and dollars. Ideally, investors should be able to withstand losses of 50% of the value of their equity investments.
- Ensure adequate liquidity reserves: Keep a few years-worth of cash needs in cash and high quality fixed-income investments to prevent a forced liquidation of equities at an inopportune time.
- Stick with the long-term plan: If nothing has changed except a short-term drop in the level of the index, your plan remains sound. Deciding to stand pat is an action.
Volatility in the equity markets has receded from the heights in February and March. We expect to see further flare-ups moving forward as the market reconciles the latest developments regarding the COVID-19 treatments/vaccines, the restarting of the economy and the upcoming election. In general, those investors that can stick with their plan and maximize their time in the market will enjoy more favorable outcomes than those that try to time the market.