Why Trying to Time the Market is a Losing Game

The U.S. stock market has returned 282% since bottoming in March 2009, following the Financial Crisis.  Since that time, the S&P 500 Index has delivered positive returns in seven out of the last eight years and appears poised to produce another gain in 2017.  While it’s true that valuation levels are above long-term historical averages, in this email we’ll explore why trying to time the market is a losing game.

As a client you may be concerned that higher stock valuation levels coupled with a long-running bull market could mean an imminent pullback.  If so, you’re not alone.  Many investors have noted that it’s been a while since we’ve had a major stock market correction (defined as a drop of 10% or more).  This makes sense given that historically, the stock market has averaged three pullbacks of about 5% per year, with one of those corrections typically turning into a 10% or greater decline.  While it has been twenty-two months since our last market correction, we’ve seen longer.  Since 1990, we’ve experienced three periods lasting longer than twenty-two months over which markets did not experience a 10% or greater pullback.  So although we’re not in uncharted territory, the historical record suggests we could be closer to a market decline than not.

Given the above facts, clients often ask why we don’t sell stocks and raise cash in order to avoid the next market correction.  It’s a fair question, but when examined more closely we find that it’s a very difficult strategy to implement successfully.

Research has shown that trying to time the market is a losing game.  One reason is that an investor has to accurately predict both when to get out of the market and when to get back in.  While it’s difficult enough to time an exit right, the odds of then correctly calling a market bottom are even lower.  Part of this relates to the nature of market declines.  Looking back to 1945, the average stock market correction has lasted just fourteen weeks.  This suggests that investors who correctly sell their stocks to cash may be sitting on the sidelines when equities surge higher, often without warning.  While moving into cash may avoid some near-term losses, it could come at the higher cost of not participating in significant market upside.

Another reason to avoid market timing relates to the nature of market returns.  History shows that since 1926, U.S. large cap stocks have delivered positive returns slightly more than two thirds of the time.  As a result, you’re much more likely to realize higher long-term gains by remaining fully invested in stocks and weathering some of the market’s admittedly unpleasant downturns.

At Parsec, instead of market timing, we recommend investors stay invested throughout market cycles.  While this can be difficult at times, investing in a well-diversified portfolio has been shown to help mitigate market volatility and provide a slightly smoother ride during market downturns.  This is because portfolios that incorporate a thoughtful mix of asset classes with different correlations can provide the same level of return for a lower level of risk than a concentrated or undiversified portfolio.  It also ensures that investors participate in market gains, which often materialize unexpectedly.

In addition to constructing well-diversified portfolios, we believe in setting and maintaining an appropriate asset allocation based on your financial objectives and risk tolerance.  We then rebalance your portfolio to its target weights on a regular basis.  This increases the odds that you sell high and buy low.

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The Benefits of Focusing on Your Long-Term Financial Goals

As your advisor, our main focus is helping you reach your long-term financial goals.  We say this a lot, but it bears repeating.  It’s worth revisiting because near-term portfolio returns and market noise can distract even the best investor from remembering why he or she invests in the first place.  For most of us, investing is about creating the life we want, giving back to family, friends, and community, and leaving a legacy.  At Parsec, our job is to lead you through difficult market periods, including times when your portfolio may lag the major market indexes.  Every portfolio will experience underperformance from time-to-time.  However, getting caught-up in weak near-term performance can actually hinder progress towards your long-term goals.

This happens when we lose sight of the big picture.  Asset class leadership naturally ebbs and flows over the course of any economic cycle, and so too will portfolio returns.  Financial behavioral scientists suggest that if we’re caught-up in near-term underperformance we’re more likely to act reactively instead of proactively.  Reacting to current portfolio performance increases the odds that we sell low, buy high, trade excessively, or even sit-out the next market run.  In other words, focusing on near-term market moves increases the odds that we hinder our long-term performance results.

In contrast, measuring your progress versus your long-term goals is more likely to increase proactive behaviors and thus improve the odds of realizing your objectives.  For example, framing portfolio returns in the context of your retirement savings target several years from now is more apt to help you keep calm during periods of market turbulence.  “Keeping your eye on the prize”, as they say, can cultivate resiliency and has the added benefit of lowering your anxiety levels.  When you’re less stressed, you’re more likely to engage in proactive behaviors like maintaining an appropriate asset allocation mix, rebalancing back to your target regularly, and staying invested during market downturns.

While we acknowledge that portfolio declines or underperformance is never fun, it’s important to recognize that difficult performance periods are par for the course.  Over time some assets and sectors will outperform while others will lag.  Rather than trying to time the market or catch the latest trend – which is extremely difficult to do – sticking with a diversified asset allocation and rebalancing regularly is a tried-and-true method for achieving your financial goals.

With that in mind, our job is to help you stay focused on the big picture.  Doing so lowers the odds of engaging in detrimental behaviors and increases your chances of success.  When you succeed, we succeed!

Thank you,

The Parsec Team

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