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.