Market Timing: Risk vs. Reward


A study released from Professor H. Nejat Seyhun at the University of Michigan examined the cadence of the stock market in two different intervals: on a monthly basis, from 1926 to 2004, and on a daily basis from 1963 to 2004. For those interested in or convinced by Market Timing, the findings of the study may be a bit of an eye-opener. Professor Seyhun discovered that not only did U.S. stocks accumulate an average of over 10% annually (Seyhun 2005, 3), he also discovered that the biggest gains always happened in extremely small increments of time. The data set from 1963 to 2004 shows that “96% of market gains between 1963 and 2004 occurred during only 0.9% of the trading days.” (Seyhun2005, 1) This leads to the inevitable conclusion that if you are interested in giving Market Timing a shot and you miss three of the best days out of the year, your potential gains would be dramatically reduced compared to those who don’t try and time the markets.

This, of course, is just on profitable days--what if you miss the days where you would normally suffer losses? Surely avoiding those must count for something and mitigate the risk on some level. But with the market index rising around 10% every year, you’ll be turning a profit regardless, and the less time you spent in the market the generally worse off you are; unless your timing is perfect and you manage to avoid all of the worst days and months, you’ll more often than not end up losing out on a chance to make money. Not only will your investments suffer in the long-term, with little distinguishable gain from missing the worst months, avoiding six of the worst months only raises your anticipated gains by a bit over 2%, (Seyhun 2005, 6).  By doing so, you’ll be just as likely to miss out on the days when the biggest gains happen; days that are decidedly more valuable to an investor than those where the market declines. As Professor Seyhun notes later in the study, “if a market timer is right 50% of the time, the probability of executing a perfectly timed investment strategy is 0.5 raised to the 948th power - or nearly zero.” (Seyhun 2005, 8)

What this effectively means for timers is this: if you’re intent on trying to time the market, you’re going to need to invest in a crystal ball first, because if you miss a few of the best days and hit a few of the worst, you’re going to be much, much worse off than someone who chose a long-term, stable investment strategy instead.

Random timing “always reduces expected wealth,” (Seyhun 2005, 9) and taking the gamble of market timing opens the investor up to a potentially devastating ‘what if’, particularly when the market is already growing at a steady rate on its own. If you’re looking to make money with relatively little risk, staying in the market is the way to go, because when the biggest gains happen, they happen fast and infrequently, and missing them could be disastrous for your portfolio.

Stangier Wealth Management can help you build a customized investment strategy. Contact us or 877-257-0057.