Can investors realistically time the market to maximize returns, especially over the long term? According to a recent study from Charles Schwab, perfect market timing is practically impossible. The firm’s research showed that most investors are better off investing as soon as possible using a buy-and-hold strategy rather than trying to predict short-term peaks and valleys.
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Breaking Down Schwab’s Study: Market Timing vs. Other Strategies
To produce their new study, researchers at the Schwab Center for Financial Research analyzed the hypothetical 20-year returns of five investing strategies using historical S&P 500 data. Each hypothetical investor received $2,000 every year, which they could invest however they like.
The investors took the following approaches:
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Perfect market timing: One investor invested $2,000 each year at the S&P 500’s lowest trading point.
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Immediate investing: One investor put $2,000 into the S&P 500 on the first trading day of each year.
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Dollar-cost averaging: Another investor split the $2,000 into 12 equal allotments and invested one portion on the first of every month.
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Poorly timed investing: One investor invested the entire $2,000 at the S&P 500’s highest point of the year every year.
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Treasuries: The final investor avoided stocks altogether and instead put their $2,000 into U.S. Treasury securities each year as a cash proxy and left it there.
Not surprisingly, the study found that perfect timing delivered the best returns. However, investing immediately was a close second, trailing the results generated from perfect timing by only about 8% over 20 years.
Put another way, not trying to time the market at all earned 92% as much as timing the market perfectly. In dollar terms, the difference was $10,537, with perfect timing returning $138,044 and no timing producing $127,506.
“The best course of action for most of us is to create an appropriate plan and take action as soon as possible. It’s nearly impossible to accurately identify market bottoms on a regular basis,” Schwab wrote in its study. “So, realistically, the best action that a long-term investor can take, based on our study, is to determine how much exposure to the stock market is appropriate for their goals and risk tolerance and then consider investing as soon as possible, regardless of the current level of the stock market.”
Monthly dollar-cost averaging also fared well. In contrast, the investor who timed their investments poorly each year beat the one who chose Treasuries over stocks, but still lagged significantly behind both the immediate investor and dollar-cost average investor. Buying only Treasuries proved the worst-performing strategy of all, and by a wide margin.
Schwab’s researchers concluded that attempting to time the market is not an advisable approach for most investors. Absent perfect knowledge of future market movements, which no investor has, it’s virtually impossible to consistently buy at the market’s lowest point. The potential gains of perfect timing over simply investing immediately are relatively small, they said, while risks of mistiming investments are substantially high.
The Limitations of Schwab’s Study
While insightful, Schwab’s study does have some limitations. For one thing, it focused exclusively on U.S. large-cap stocks rather than including other asset classes. Most portfolios will diversify beyond the S&P 500 and post returns that will vary from these results.
Additionally, the analysis relies on back-testing and hypothetical scenarios rather than real investor experiences. Market conditions and individual investment amounts could produce different relative results than Schwab’s assumed models. Conventional investing advice warns against basing decisions solely on hypothetical simulations. However, the report still offers valuable insights for those concerned with maximizing their portfolio’s allocation.
So, What Is Market Timing?
Market timing refers to buying and selling investments based on predictions of how prices will fluctuate in the present and future. The goal is to buy assets just before prices rise and sell them just before prices fall. In theory, perfect market timing would allow an investor to consistently buy low and sell high.
However, predicting short-term market movements is extremely difficult in reality. It also essentially requires the investor to be right twice: they must perfectly time both their entrance to and exit from the market. A slight miscalculation in either transaction can have a significant impact on their eventual returns.
In fact, previous research from Retirement Researcher found that missing out on the best single month in the market between 1926 and 2016 would have left a market-timing investor with 30% less money than an investor who simply used a buy-and-hold strategy during that time.
Other Popular Investment Strategies
The investment strategies Schwab studied represent popular approaches, but many others may prove suitable for specific situations. For instance, here are some popular strategies investors use:
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Value investing: This seeks out underpriced stocks trading below their inherent worth, meaning it looks for marketplace mispricing.
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Index investing: This looks to construct portfolios that match market benchmarks. It aims to capture broad market returns at a low cost, with securities like ETFs.
Bottom Line
The idea of market timing is alluring, but not likely to represent a reliable strategy in the real world. For long-term investors saving for retirement or other financial goals, adopting a patient buy-and-hold approach likely represents the optimal marriage between growth and risk management. Additionally, greater diversification among asset classes can produce more balanced returns with less overall risk.
Investing Tips
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Unsure about which investment strategy is right for you? Consider consulting a financial advisor to discuss your options. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Source: finance.yahoo.com