The Importance of Timing Market Returns: Sort of
Austin Colby, CFP®, MBA
You can’t time the market. At least I can’t. Market timing is an investment hypothesis that has been tried for the 240 years of stock exchange history in the United States.
The basic idea is to buy an investment when it is “low” or undervalued, and then sell that investment when it is “high” or overvalued. The problem is that I don’t know when the “low” or “high” has truly occurred. I know when investments are “lower” and “higher”, because those terms are always relative to some reference point in the past.
Here is an example: in July of 2008, crude oil (WTI – West Texas Intermediate) was trading at over $145/barrel. By December of 2008, the price had dropped to $30/barrel. I had conversations with clients at $100/barrel where the client told me oil was low and we should buy. My response was that oil was lower than it had been, but I had no idea if it was low. We had the same conversation at $80/barrel and again at $60/barrel. By April of 2011, the price of crude oil had rebounded to $113/barrel. Fast forward to January of 2016, and it was all the way down to $26/barrel. We had the same conversations as before – and just as before, we would have been guessing – and would have guessed wrong on the way down.
Here is the catch if you are guessing on a price being low or high: you have to guess right twice. You have to guess right near the bottom – low, and also at the top – high. Back to the oil example above, if you had successfully guessed low and purchased oil at $30 - $40/barrel, down from the $145/barrel high, but never sold when it rebounded, you would have seen the price go all the way back down to $26/barrel in your 7 years of ownership. To have successfully timed the oil market, you would have had to buy at $30/barrel, sell at $113/barrel, buy back at $26 and sell again at $75/barrel…etc.
Good luck timing this market.
You can see by that exercise the futility (and risk) of trying to time, or guess, on any one individual investment purchase.
In my opinion, the importance of timing the market means simply that while you are accumulating wealth and adding to your portfolio, you need to capture as much of stock market returns as possible. As part of that process, you will experience the inevitable downs of the stock market. While you are distributing money from your portfolio, you cannot afford to take part in all of the downs, and therefore will not capture as much of the upside either. This investment strategy helps protect you from sequence of returns risk (the risk that your early years of retirement will carry dismal stock returns). I’ll expound on that risk below.
We break those time periods into two broad categories: Accumulation Mode and Distribution Mode.
Accumulation mode means you are more than 5-7 years from needing to draw on your portfolio for regular income. During this time, it is appropriate to have the majority of your portfolio invested in markets that offer the best long-term returns, primarily stock-based investments. Generally, with those quality long-term returns come the short-term pullbacks. However, as long as you are not withdrawing money during this time (and ideally actively adding to your investments), the timing of the short-term negative returns typically should not impact your long-term returns over any specific period of time.
For example: You start with $1,000,000 invested. If over a 10-year period, your portfolio earns 13% seven times and loses 8% three times, the 10-year compounded rate of return will be 6.2%/year, no matter the timing of those above returns. If you earn 13% the first seven years and lose 8% the final three years, or if you lose 8% the first three years and earn 13% the final seven years, your long-term rate of return is identical, AND you would have the same dollar amount in your portfolio at the end of the ten years: $1,830,000.
Distribution mode means you are within two years of needing to withdraw regular income from your portfolio. During this time, the timing of your returns makes a huge difference in your long-term portfolio value. It is appropriate to have your income needs in more conservative markets, primarily bond-based investments, with the balance of your portfolio still invested for better expected long-term returns in stock-based investments. The short-term negative returns that more aggressive, stock-based investments can bring need to be minimized, especially during the early years of withdrawing money from the portfolio.
Using the same example as above, only also assuming an annual withdrawal of $42,000 (increased each year by 2.2% for inflation), you can see the impact of the early negative returns:
Portfolio value with negative returns at the end of the ten years: $1,298,018
Portfolio value with negative returns at the beginning of the ten years: $1,017,275
Even though the 10-year rate of return for the portfolio in both examples would be 6.2%/year, one portfolio would be $280,000 higher because of the timing of the returns while withdrawing money.
What does this mean to you?
When designing portfolios, we start with what our clients are trying to accomplish. Most often, those goals are accumulating enough money to make work optional, and then making sure that the money that was accumulated never reduces down to zero during the client’s lifetime.
The system we have developed and refined is designed to help our clients achieve just that: primarily by capturing as much of the upside while accumulating money, and minimizing the downside while distributing money. We continually review our processes, and have ongoing meetings to research and analyze the investment options inside of our client portfolios. As we make shifts in those processes over time, you can be sure we are doing so to ensure that we are working on your behalf, to help you achieve your desired financial outcomes.
1) YCharts, WTI Crude Oil Spot price history.
Because The Wealth Group, Austin B. Colby & Associates is independent of Raymond James, the expressed written opinions above are our own and not necessarily reflective of Raymond James’ opinions.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. The examples listed throughout the material are hypothetical and for illustration purposes only and does not represent an actual investment or portfolio.
Actual investor results will vary. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability. Holding stocks for the long-term does not ensure a profitable outcome. Investing in oil involves special risks, including the potential adverse effects of state and federal regulation, and may not be suitable for all investors.