To earn a decent return, you need to include risky assets such as stocks in your portfolio. Equally important, you have to hold onto those stocks in both good times and bad. That may be hard to do when it seems the stock market is getting overheated – and harder yet just after it has crashed – but in the long run, you will almost certainly be further ahead.
Deep down, though, most of us do not really believe that. It is hard to put all our faith in the stock market when memories of the 2008-09 financial crisis are still fresh. In that two-year period, investors worldwide incurred the biggest losses since the Great Depression. And let's not forget the dot-com bubble. When the bubble burst in March, 2000, it wasn't only the shares of high-flying dot-com companies that plunged, the broad-based S&P 500 index fell from over 1,500 to 800.
Living through two devastating bear markets within a relatively short time frame is enough to test anyone's resolve. The fact that the current bull market is now getting long in the tooth makes some investors just that much more skittish. If you need some assurance that staying fully invested ultimately pays off, the following illustrations should help.
In the first example, Tony and Nancy each had $100,000 in assets as of Jan. 1, 1996. Tony invested 100 per cent of his money in T-bills the entire time. Nancy put 60 per cent of her money in Canadian stocks and 40 per cent in government-issued long-term bonds. The accompanying chart traces the changes in their account balances through to Dec. 31, 2015. Even though Tony avoided both market crashes, Nancy is way ahead by the end of the period.
Big deal, you say. No one in their right mind would invest all their money in T-bills for 20 years, not even Tony. The smart thing is to invest in stocks and bonds, get out when the markets start to get overheated (such as now), and then get back in after the blood-letting. Good luck with that. Look at what happened to Robert Prechter, the market guru who was celebrated for calling the crash of 1987 two months before it happened. He stayed in cash throughout the 1990s and in the process missed out on the biggest bull market of all time when the S&P 500 rose 526 per cent.
But let's not pick on Mr. Prechter; no one is consistently good at market-timing except maybe Biff from Back to the Future II. Even if you timed your market exit and re-entry reasonably well, you would still be hard pressed to do better than simply staying fully invested. This is shown in the second example below.
Let's assume that Sandra is one of the most successful market-timers of all time. In the period between 1996 and 2015, she starts off by investing her $100,000 in a 60 per cent, 40 per cent portfolio (the same as Nancy). It does quite well for the first four years with an overall return of 62 per cent.
By January, 2000, Sandra starts to worry that stocks are getting seriously overpriced. She sells off all her stocks and bonds and puts her money into safe government T-bills. The timing is great as the dot-com bubble bursts just two-and-a-half months later. She stays in T-bills throughout 2000 and 2001 and thereby avoids some serious losses. By January, 2002, Sandra gets back into the market. This turns out to be a tad early, but she still avoided most of the carnage. By 2003, investment returns surge back into positive territory and they stay that way for several years.
In December, 2005, the subprime lenders in the United States make Sandra nervous so she repeats the exercise, selling off her portfolio at year-end and going back into T-bills. By being totally out of stocks in the years 2006 to 2010, she is one of the few investors to survive the 2008-09 global market meltdown with all of her money intact.
This time, she makes sure not to go back into stocks too early so she waits to do so until January, 2011.
After that, it is practically all blue skies as far as investments are concerned so she retains her portfolio until 2015. (By the way, I built in transaction fees of 0.5 per cent for the liquidation and rebuying of securities each time.)
I doubt any real-life investor, professional or otherwise, timed the market as well as Sandra did during that 20-year stretch. It would have required an exceptional level of prescience or luck. While she didn't get the market tops and bottoms right to the exact month, she still did very, very well. Any investment-management firm would be proud to have her as their star manager.
And what is Sandra's reward for displaying such uncanny skill and timing? The second chart shows the result. For the sake of comparison, it also includes Nancy's results, who as we saw earlier maintained her portfolio the whole time. Somewhat unbelievably, Nancy did better.
To ensure this period wasn't an anomaly, I conducted a similar test over the years 1924 to 1940, a period that spanned the great market crash of 1929 and the Great Depression. The result was very similar.
Market timing ultimately fails because it is impossible to sell at the very peak or buy at the very bottom. Even if, like Sandra, you are 98 per cent correct, you are still going to be better off in the long run just staying fully invested.
Industry professionals know that market timing is a mug's game, which is why no investment firm (to my knowledge) professes to be a market timer. Yet virtually all of them acknowledge that they reduce (or increase) their positions in stocks when they think they are getting overpriced (or under-priced). So maybe they are all closet market-timers? The second chart suggests this exercise might be a waste of time and certainly not something that amateur investors should be trying. The takeaway is to remain fully invested at all times.