Market studies show that the average investor return can lag the market by as much as 7% over the long run depending on the period. The leader in these studies is a company named Dalbar which releases these intense investor behavior studies on an annual basis. This return gap is commonly referred to as the Behavior Gap. The greatest reason that this behavior gap exists is due to poor investor behavior, and most commonly this is due to something called market timing. Timing the market is a loser’s game, plain and simple. Timing the stock market presents itself in many forms such as buying/selling based on the news or waiting to purchase a stock until a specific thing happens or the market attains a specific level. Attempting to time the market is probably the most common mistake made by every investor, and it’s almost impossible to avoid due to human nature. We, the investors, are simply human! We have countless biases that lead us to believe we are smart enough, or skilled enough, to perfectly time the purchase of a stock. Not only must we be aware of our own biases, but actively combat them in our behaviors. Below I address some of the most common biases the investor must remain vigilant against.
Overconfidence Bias. This is the most common bias that gets the average investor into trouble. Everyone thinks that they have the ability to go select the right stocks at exactly the right time to beat the market. An example of this would be an investor who refuses to invest in index funds because they believe in their ability to select individual stocks. Another example of this would be an investor pulling out of the market or even waiting to invest in the market due to their "intuition" that it is the right time to be investing or not investing.
Confirmation bias. This bias happens when we seek out information that we already believe to be true, thus supporting our initial judgment or decision. For example, an investor may reflect on a decision they have previously made which had a positive outcome by chance. The investor, who is confident in his past decisions despite the outcome being lucky, seeks out information that backs up that decision and uses that to make another similar decision. The investor is not seeking out new information that could lead to a more informed decision, they are simply confirming their pre-existing bias by making the same decision, which might not be so lucky this time, over and over again.
Recency bias. This bias comes when we take recent events and outcomes into account and place a much heavier weight on them than events of the past, simply because they just happened! A timely example of this would be to place a heavy weight on the news that the next COVID variant will halt US GDP growth and thus tank the stock market. If you simply fall prey to the 24/7 media stream, whose primary goal is to gain viewership through controversial headlines, and react accordingly, you might overlook what happened the last several times that bad news broke regarding COVID; the market continued roaring upwards over subsequent months. Recency bias causes us to forget about the historical, long-term, positive returns of the stock market through depressions, world wars, and pandemics. Recency bias might also overshadow your long-term financial goals and the necessary risk you must take in the stock market to reach them. Confirmation and recency bias are two of the reasons that humans try to time the market, now let’s jump into why this is so detrimental to your financial goals.
"The only value of stock forecasters is to make fortune tellers look good" says Warren Buffet. This is coming from one of the greatest investors in the history of time. If he says timing and predicting the market is impossible, why would you think that you can do it? No one knows where the market is going in the short term, and it is best to admit this and hold and invest through the ups and the downs. If you decide that are going to successfully time the market, you need to be right twice. You need to know when to buy/sell on the front end, and when to buy/sell on the back end. For example, if you are selling you need to know exactly when to get out and exactly when to get back in. History and data show us that this is impossible to do reliably. It’s like gambling, you’ll be right sometimes, and wrong other (most) times, but over the long term this decision could throw off your financial plan in a big way.
The below graphic illustrates what would’ve happened if you held the S&P 500 index fund for 30 years starting on January 1st, 1990, but due to market timing, you miss out on the best trading days of that period. The results are astounding. By just missing the best trading day, your return on $1,000 goes down by $2,122, leaving you with 10.4% less than the same investor who stayed the course. That's a large penalty for being out of the market for one day in 30 years. If you are unlucky enough to miss the best five days in the market, you would lose 26% of your total return. These numbers are mind-blowing when you take a look at the effects over long periods such as 30 years.
Here's another example to bring it closer to home with a more recent and plausible event. Let’s say that you had a portfolio of $1,000,000 the morning of March 12th, 2020. On March 12th, 2020, the S&P 500 dropped 9.51% due to COVID panic. On the very next day, the S&P 500 rebounded 9.29%. Let's say you sold your stock portfolio at the end of the day on March 12th out of fear that the market was going to continue to spiral downward due to the unprecedented global pandemic. This would leave you with $904,900. Let's assume you invest at the very end of the next day after you saw the market rebound, so you missed exactly one day in the market. You would have enjoyed the large rebound and new highs of the stock market that we have seen over the last two years since the start of the pandemic, and your account would be up right now from that dreadful March 12th day. You might think that the one missed day is no big deal, but over a long period of time, it is a very big deal. From the end of the day March 13th, 2020 until now, the S&P 500 is up 66.01%. This means that based on the price of the S&P 500 alone (ignoring dividends) you would have $1.502,224 if you pulled out for that one day. The same investor with $1,000,000 that stayed invested would have $1,641,782, a difference of $139,557 in just under 2 years. This is a staggering amount of money resulting from a decision made to time the market, and sit it out for just one day! Assuming a 7% real annual return over the next 30 years, the market timer has $11,435,315.95 while the diligent investor has $12,497,661. This one day mistake has now grown to $1,062,346. These numbers get even larger if you add more days out of the market, or start with more than a $1M portfolio.
The graph below illustrates what would happen over 30 years from March 12, 2020, in the two scenarios assuming a 7% real annual rate of return. The cost of just this one mistake gets bigger and bigger over time. If we looked a 40, 50, and 60-year time frames, this mistake could cost families millions of dollars. This is also starting with only $1 Million, and missing one single day in the market. Given that many investors jump in and out of the market seemingly on a whim, missing even more than just one day would exponentially increase overall loss.
Cost of Being out of the Market for One Day on March 12, 2020
Market timing also affects us psychologically in ways that are extremely unhealthy. Watching the market closely to decide when to sell or buy with your life savings can take a significant toll on both your physical and mental health. High levels of sustained stress could lead to adverse health outcomes such as high blood pressure, sleep problems, or a heart attack. Not to mention the mental toll attempting to time the market results in such as depression or regret if a decision does not yield optimal results. Unfortunately, an investor who is suffering mentally and physically is only more likely to make poor financial decisions.
What This Means
The bottom line of this is that you need to stick to your financial plan that is personalized to meet your goals. It does not matter what the market does in one day, week, month, or even year! It doesn't matter what your neighbor or your friend at work is doing with their portfolio. You have to look at your family's financial situation, set financial goals, and choose a portfolio with an asset allocation that will allow you to successfully reach those goals! Temporary market downturns are completely normal and should be expected in any market. The key during tumultuous times is to walk away from the TV and read less news. Take a deep breath, and do not make a market decision based on fear. Spend more time with your family and revisit your financial plan, especially focusing on the areas that you can control such as increasing your income and managing your cash flow, insurance, taxes, and estate planning.