In volatile markets, it can be tempting to try to ‘time the market’ or wait for a clear recovery. However, history shows that investing in this manner can lead to long-term underperformance compared to a strategy of remaining invested.
Staying resolute to a plan
A key principle of investing is staying resolute to a robust investment strategy, rather than reacting to short-term swings in the prices of financial assets.
High inflation and rising interest rates created a challenging market environment from the start of 2022, leading to sharply lower prices in some asset classes. These events are not common, so when they happen, they can encourage some investors to deviate from their long-term strategy. However, doing so can be detrimental to building long-term wealth.
Timing the market doesn't work
When markets are volatile, it can be tempting to try to ‘time the market’ with the hope of lower asset prices later on. However, this approach can be costly in terms of performance.
The chart below shows the behaviour of S&P 500 Exchange Traded Fund (‘ETF’) investors during the Covid-19 selloff in 2020. The strongest selling (outflows) in ETFs only occurred around the time the S&P 500 was finding its lows.
The strongest buying (inflows) following this occurred only after significant gains had already occurred, suggesting that many of those who left the market re-entered but ‘too late’ and missed out on positive returns that they would have enjoyed had they stayed invested.
This pattern of getting both out of the market too late and getting back in too late is common during down markets, but is a recipe for long-term underperformance1.
Trying to 'time' the S&P 500 index
We show this by examining the hypothetical performance of a ‘Consistent Investor’ and a ‘Market Timer’ who each invest a hypothetical$100,000 into the S&P 500 index on 31st December 1999, near the peak of the dotcom bubble. The Consistent Investor then simply stays invested.
The Market Timer sells entirely into cash (3-month Treasury bills) whenever the S&P 500 index falls by 10% or more in a quarter and then re-enters only after two consecutive quarters of positive returns.
We see that the forgone returns from trying to time markets add up over time. The Consistent Investor has outperformed the Market Timer by 175%2 since 1999.
Sitting on the side-lines and waiting for clear recovery could mean missing opportunities and long-term underperformance compared to being invested.
Turning points are hard to identify
Timing the market can be costly because identifying market turning points is difficult. The best days for asset returns often occur very close to the worst days during periods when prices are generally trending downwards, as the below chart illustrates for the S&P 500 index.
Since 1970, more than 90%3 of daily S&P 500 index gains of 4% or more occurred when the index was more than 10% below its most recent high. The chart below shows that there are often multiple rallies of this strength during down markets, which can make catching genuine turning points challenging.
Additionally, missing out on being invested during these days can be costly.
Being invested can be a way to meet investing goals over the long term. However, challenging market conditions often lead investors to exit the market and remain uninvested until a recovery appears to be clear.
ETF investment flows suggest that investors often fail at market timing – waiting until both downturns and then recoveries are clearly established, and in this way exiting the market ‘too late’ near the bottom, and also re-entering ‘too late’ and missing much of the recovery.
History shows that this isn’t surprising given that the best and worst days for market performance often occur close together, with some of the strongest performances occurring during overall market downturns.
Over time the opportunity costs (compared to remaining invested) of such mis-timing can compound and lead to significant underperformance compared to a strategy of staying invested.