Money Management - November 2005

Market Timing

Tempting Opportunity, Exceptional Risk

by Doug Fries

In spite of what people say about the journey being more important than the destination, for investors it is perhaps the destination that matters most. While keeping an eye on long-term goals can be difficult during periods of near-term upheaval and disappointing returns, bumps experienced along the way should not be allowed to cause unnecessary, and often unproductive, detours.

Through the end of May 2005, the S&P 500 Index had barely moved since the beginning of the year, with a total year-to-date return of -0.95 percent. Adding to the potential for disappointment, this year’s returns-to-date followed on the heels of a strong 2004. Still, even last year saw the market trend up and down around modest returns until the final two months, when a sudden upswing accounted for nearly the entire annual return of 11 percent. Through periods of fits and starts in the market, it’s critical to remember both the importance of a long-term strategy and the potential pitfalls of market timing.

By now the lesson is familiar: the risk of market timing is much greater than the reward, because the chances of getting it wrong are far greater than getting it right. However, human nature being what it is, the temptation exists to wistfully look back and think what could have been. The problem is that the reality is all too often much worse.

It is easy to see why market timing’s perceived opportunity is tempting. If investors had remained in the S&P 500 Index for the entire three-year period ending April 30, 2005, they would have achieved an annualized total return of 4.2 percent. However, if they had been lucky enough to be out of the market for the worst two months of that period, their returns would have jumped to 11.3 percent. Perhaps more tempting is that five-year returns would change from negative to positive, simply by avoiding only the three worst months.

On the flip side, what if the market timers had experienced very bad luck and were out of the market for what would turn out to be the best months of return? For the three-, five-, and 10-year periods ending April 30, 2005, they would end up with worse returns by missing just the best 5 percent of the months during those time frames. Instead of ending three years with $1,133, our investors would have $962 left from a $1,000 investment. A 10-year period shows the most dramatic results: missing the best 5 percent of the months (six months out of 120) would mean that an original investment of $1,000 would result in $1,633, compared to $2,656 if they had just stayed put.

It is interesting to note that over the entire 10-year period, the S&P 500 Index had positive monthly returns nearly two-thirds of the time. This means that by randomly selecting months to be out of the market, an investor has a greater chance of diminishing returns rather than improving them.

Market timing should not be confused with tactical asset allocation. Where market timing is very short-term oriented, often motivated by fear or greed, asset allocation is done to maximize return potential by adapting to longer-term trends as part of an overall investment strategy. While recent returns within the equities markets may make some impatient, it’s important to remember that, for investors at least, the journey is all about the destination. Attempts to avoid bumps along the way can too often lead to missing the mark.

Doug Fries
Doug Fries is the regional president of the Las Vegas-based private wealth management office of Mellon Financial Corp.