The difference between 'timing the market' and 'time in the market'
During market lows, potential investors may be apprehensive about entering the market, opting for a wait-and-see approach before investing in a certain stock or product. For those who are already invested, it can be incredibly difficult to resist the temptation to get in or out of an investment in anticipation of a potential jump or loss.
While the duration of the so-called bad patch can’t be predicted, what goes down must surely come up. But if you try to time the market, will you get it right it? At the end of the day, nobody knows what will happen in the future; when the next market crash will be and whether certain share prices will claw back losses after taking a fall.
Nobel Laureate and famed economist William Sharpe found in 1975 that a market timer would need to be precise 74% of the time to beat a passive portfolio. Even a slight outperformance most likely wouldn't justify the efforts - and given that even the specialists for the most part come up short at it, market timing shouldn't be your exclusive methodology for investing, particularly when it comes to building your retirement nest egg.
What has been proven to be more effective over the years is time in the market as opposed to timing the market, as the adage goes. Emotional decisions lead investors to enter the market near the top of the cycle and leave near the bottom. By staying invested through the cycle you will be significantly better off.
An example of net flows into equity funds versus market returns
Instead of waiting for the ‘right time’ to invest, it is advisable to rather ensure that you have enough time in the market. Staying invested over the long haul, in a well-diversified portfolio, has proved to be much more effective than waiting for the most opportune market moment.
Investors who choose to ride things out on the side-lines in the hope of correctly timing the market may end up missing some of the market’s best days and give up a lot of long-term capital appreciation potential. The reality is that it is extremely difficult to predict what is going to happen with markets both over the long and short term, even for expert economists and veteran financial players. We do not have access to a crystal ball, but what we do know is that staying out of the market, and missing some of its best days, with the aim of trying to time the market is more of a risk to investors.
Staying out of the market: South Africa example
At the same time, if we look at the performance of the S&P 500 from beginning January 1998 to end December 2017, six of the best 10 days occurred within two weeks of the 10 worst days. The best day of 2015 – August 26 – was only two days after the worst day (August 24). This reveals the perils of trying to time the market.
Lows in the market often result in emotional decision-making as investors may look to profit off a share that has become cheap or cash out their investments in favour of safer instruments amid fears of a market crash. However, investing for the long term while managing volatility – through diversification – can result in a better retirement outcome.
A diversified investment is a portfolio of various assets that earns the highest return for the least risk. Different industries and sectors don’t move up and down at the same time or at the same rate. If you mix things up in your portfolio, you’re less likely to experience major drops, because as some sectors encounter tough times, others may be thriving.
Ultimately, diversification works to safeguard investors’ portfolios against volatility in certain sectors to allow for a more consistent overall portfolio performance. This means that investors do not have to ride things before making an entry into the market, but rather ride things out while staying invested to benefit from long-term capital appreciation.
Bernard Drotschie is the Melville Douglas Chief Investment Officer.