Timing the Market

01/10/2009 05:12 am ET | Updated May 25, 2011

According to data by Davis Advisors Funds examining the S&P 500 returns in the 15 years span between 1993 and 2007, the patient investor who remained invested and did not try to time the market received an average annualized return of 10.5% per year. The investor who missed just the best 30 trading days over this 15 year period saw their return plummet to 2.2%. Even missing merely the best ten days over 15 years made a very substantial detrimental impact, down 3.4 percentage points to an annual gain of 7.1%. And an investor needed only to miss the best 60 days for their return to turn negative!

Stayed the course: 10.5%
Missed ten best days: 7.1%
Missed 30 best days: 2.2%
Missed best 60 days: -3.2%
Missed best 90 days: -7.4%

The caveat about that average 10% return is that one has to grasp the meaning and context of the numbers. British Prime Minister Disraeli used to refer to "lies, damn lies and statistics", perhaps in escalating order of perniciousness. If you examine almost any multi-decade period throughout the history of the stock market, the standard deviation is approximately 15%. If we take the 10% return, such standard deviation implies that 95% of the time the market will return somewhere between -20% and +40% (because in normal distributions, about 95% of the time returns should fall within two standard deviations). That kind of chaos is unhelpful if you are trying to reliably predict future return. Further more, the market's real distribution is non-normal, with fat tails, meaning that a minority of months (and indeed a minority of stocks) are responsible for most of the index gains, while most months (and most stocks) are below average.

If statistics can't help, what about following the advice of market strategists and economists? It has been said that stock market forecasts were invented to make astrology look good. In my view, there are two types of stock market forecasts. In order of increasing sophistication, they can be referred to as the naïve and the gullible. The naive forecast is based on linear trend extrapolations. The gullible forecast is based on analysts' earnings estimates. Neither is very useful, although Wall Street gladly provides plenty of both. Mankind has always had an inordinate desire to know the future, and this one is exploited just as fully as any other human passion (think gambling, liquor etc.). Investors are almost always better off sticking with predictions about the past, and never about the future.

Another caution I would offer is that buying the market mechanically at any price is a bad idea. Dollar Cost Averaging, a theme popularized by so many financial advisors, simply does not work. There are times when the danger signs are obvious and the market is clearly expensive, and there are times when it is plainly cheap, with no need to delve into economic analysis or try to fine-tune your entry points. For example, the market capitalization of all stocks as a percentage of GDP is 59% right now, compared to the long term average of 79%.

Why, then, would you try to time the market? It is really easy to miss the best 60 days over 15 years, thus getting a negative return in a bull market. Indeed, even those who get out of the market at the first sign of danger and thus sometimes are able to side-step a large decline, almost always miss the rallies that follow.

It is foolhardy and utterly unrealistic to expect to call the tops and bottoms of the stock market (the only people who have been known to consistently do that are the liars). Unless you have some special insight, it seems so much more sensible to simply stay invested. And it has the added benefit of more efficient tax treatment and lower transaction costs.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment partnership.