Market crashes are scary.
When they occur, people panic sell their positions out of fear or losing everything.
They sit on the sidelines and wait for the perfect time to reinvest and ride the wave back up.
This strategy appears logical as it’s easy to identify market tops and bottoms when analyzing past market cycles. The difficulty lies in doing this accurately in real time.
Seasoned investors know this so they abstain from trying to time the market.
Here’s why you should not attempt to time the market.
1 – The stock market is on an unimpeded upwards trend
Capitalism works in cycles on expansion and contraction.
An economic cycle is made up of growth cycles, which lead to higher highs, and contractions, which lead to higher lows. Over the long term, the trend line goes up.
When the economy grows, everything is dandy, but when it contracts, people panic. Every time a crisis occurs, people think it’s the worst ever and the system will collapse. Over the past 40 years, there have been 5 major crashes, some of which ravaged the world economy.
Nevertheless, economic activity always returns and world GDP keeps rising. In 2019, the US GDP reached its all time high of 21 trillion 482 billion dollars. The coronavirus is currently wreaking havoc but if we take a step back we can assume it’s just another contraction phase preceding the next growth cycle.
The stock market, which is a reflection of the economy, work in the same way. It also has expansions, peaks, recessions, troughs and recoveries.
The longest and harshest bear market was the Great Depression of 1929. However, since 1946, there have been far more bull markets than bear markets. In fact, the US had 50 years of bull markets, 8 years of bear markets, and 15 years of recoveries. Over the long term, the gains you made during bull markets far outweighed the losses you incurred during bear markets.
Thus, the longer your investment horizon is, the more chances you have of making money and avoiding losses. Experienced investors know that capitalism is cyclical so they don’t panic when a crisis occurs.
2 – Sitting on the sidelines is costly
You may think that sitting on the sidelines during a bear market is smart because you will miss the market’s worst days. This is theoretically true but the reality is slightly more complecated. Incredibly, since 1950, the S&P 500’s 15 best days all occurred during bear markets. Some of the market’s best days occur during bear markets, not bull markets.
For example, the 2007-08 financial crisis was very severe and many investors sold their positions fearing they would lose all of their capital. They remained on the sidelines hoping to wait for the right time to re-enter the market. The problem is many of them re-entered too late and missed many of the market’s best days, meaning they posted worse returns than investors who kept their money invested and kept buying as prices fell.
The following graph shows the value of a $1,000 investment in the S&P 500 from 2009-2018. If you missed just the market’s best 30 days over this period, your total return was actually negative.
Below is a chart illustrating the differences in returns between staying invested over the course of a whole year versus missing the best month of the year from 1970-2018. Sometimes, missing the best month of the year only results in slight differences in returns. However, other years, the difference can be massive. A 1-2% yearly difference may appear benign, but over the long term they add up. If you post a 10-20% differences just a few years, the difference is massive.
For the vast majority of investors, trying to time the market inevitably results in missing out on significant gains.
This last study will illustrate this point even more clearly.
3 – Tiffany, Brittany & Sarah
I believe it was first published on Reddit but numerous websites have since republished it to demonstrate the fact that time in the market beats timing the market.
In 1979, Tiffany, Brittany and Sarah each decide to invest $99,000 in an S&P 500 index fund from for the next 41 years. However, they adopt very different strategies.
i) Tiffany’s Terrible Timing
Tiffany wants to time the market in order to invest at the best possible time. Thus, she saves $200 per month in a savings account at 3% interest waiting for the perfect moment to inject her savings. Unfortunately for her, she has the worst possible timing and invests her money at the peak of the bull markets, the day before the worst crisis of the period start. However, she never sells her positions. After 41 years of investing, her $99K becomes over $770K, meaning her buy and hold strategy multiplied her initial investment by a factor of 7.8.
ii) Brittany’s Perfect Timing
Like Tiffany, Brittany also wants to invest at the best possible time so she also saves $200 per month in a savings account while she waits for the perfect buying opportunity. However, unlike her friend Tiffany, Brittany has the uncanny ability to time the market perfectly. She manages to invest when the market hits rock bottom, on the eve of the recoveries. Like Tiffany, she also never sells her positions. After 41 years, her $99K grows into a very juicy $1.123 million.
iii) Sarah the Consistent Investor
Sarah decides to implement a very different strategy than her friends. She knows it’s difficult to time the market so in 1979 she decides to set up a $200 per month auto investment in the S&P 500 index fund for the next 41 years. Thus, she invests during bull markets, during bear markets and every single month in between. In 2020, Sarah opens her account and discovers that her portfolio is worth $1.6 million, which is nearly more than $500K than her friend Brittany.
The moral of the story is that you should invest early and regularly, irrespective of whether the market is going up or down.
Long term investors should not fear market corrections, downturns and crashes. On the contrary, market downturns are the perfect opportunity to average down your costs and buy undervalued assets – namely index funds that track the performance of major stock markets – at a steep discount.
The data is clear: Over the past 10 years, active managers have largely underperformed the S&P 500 benchmark. People are waking up to the fact that over the long term, the S&P 500 outperforms active managers. If you’re starting out on your investment journey, you should definitely invest in an index funds rather than individual companies. Simply set up a brokerage account, determine an amount you wish to invest every month and let compound interest do the work for you.
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.