Which is the right time to invest? Nobody knows. Yet, decades of Hollywood movies and the myth of “playing the stock market” may lead us to think that anticipating market trends and trading on gut feeling is what it takes for an investor to be successful. We could not be any more wrong. Reality is different, and professional investors, asset and investment managers know well that time – not timing – is what pays off in the long-term.
Instead of trying in vain to forecast the future, investors that stay invested and build time in the market benefit from executing their long-term plan with discipline. Especially when markets become turbulent, we see sticking to this approach as fundamental: only acting out of a rational, scientific and thought-out process can manage emotions, volatility and drawdowns and ride the markets when they get rocky — running a marathon, not a sprint.
The Enemy You Don’t See
Making bad decisions because of gut-feelings is not something that happens only when we talk about investments. There is a vast literature – from psychology to behavioural finance – that has investigated how our decision-making mechanisms become temporarily blurred when we experience intense feelings, such as euphoria or stress.
On top of that, the interaction with other people also tends to influence our judgments and our ability to see clearly what is going on. Ironically, it is exactly when we need it more, that our instincts fail and our emotions lay us a trap.
For example, this is the case of the so-called “Fear Of Missing Out” (often shortened in the acronym FOMO), a concept introduced by Dr. Dan Herman in the early 2000s. With this term, we indicate the constant fear of regret and, at the same time, our desire to stay continually connected to what the others are doing.
Eventually, what happens is that we tend to follow other people’s activities just because we do not want to be left out and not because we really want it.
Indeed, it is not difficult to believe that this kind of fear is widely common when people invest in financial markets. For example, when volatility – the degree of ups and downs of the price of securities – increases in moments of high uncertainty or bear markets, it is quite common for investors to herd and sell their assets at fire prices just to get out of the market as quickly as possible.
Once we know this, it is easy to see why – especially when the markets get rocky – we need to learn how to be rational, scientific and disciplined in our investment process.
In this sense, instead of trying to time the market – to sell at the top and buy at the bottom – professional investors, asset and investment managers know well that what pays off in the long-term is to ride each market cycle and build time in the market.
Eventually, staying invested or trying to anticipate the market will make a great difference in the final performance that our investments will achieve.
Indeed, there are several reasons why building time in the market is a good strategy to navigate uncertainty and to grow capital in the long-term – to run an investing marathon rather than a series of lucky sprints.
As we are going to see, the key lies in a dynamic, systematic and long-term approach driven by the continuous application of the scientific method to build robust portfolios, well-positioned to exploit opportunities as they arise while keeping tight risk management to face each possible scenario.
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Timing The Market Is An Uphill Battle
There are many investment strategies that aim to anticipate or forecast future market movements to profit. To a certain extent, timing the market is based on the ambitious – yet unlikely – idea that people are able to correctly predict the future.
In this sense, if an investor is able to predict a rally (or crash) better than the rest of the market, he will buy (or sell) the securities in advance and profit from the change in price. Eventually, it all comes down to knowing things beforehand, and having an advantage in terms of information.
As we are going to see, because of their structure and complexity, financial markets do not lend themselves to be easily understood. As a consequence, they are very difficult to interpret or forecast. The reason for that is twofold.
On the one hand, we have the so-called price efficiency, meaning that as the demand and the supply are constantly matched through an auction mechanism, the price constantly reflects what people think about the value of any given security.
On the other hand, we have the Keynesian “animal spirits”, meaning that the direction taken by markets is highly influenced by investors’ sentiment and behaviour, which as we have seen before can be highly irrational or subject to several cognitive biases that can amplify or reduce the impact on prices, and lead investors to over or underreact to the latest news coming to the market.
Yet, according to which one of the two above-mentioned forces prevails, financial markets can temporarily depart from “pure” efficiency and let some inefficiencies arise, exploitable by investors that have superior information.
However, those inefficiencies tend to be short-lived and quickly removed for the same reasons that allowed them to exist: as soon as they are systematically exploited, the information gap closes and so does the profit associated with it.
The result is that whoever chooses market timing as an investment strategy faces an uphill battle: not only must they continuously look for new opportunities in the market because they fade quickly, but they must do so by concealing their knowledge to the rest of the market. In other words, a mission that seems not only impossible but, to a certain extent, pretty useless.
Indeed, if we imagine sticking with this strategy, we would need to compare our performances with a benchmark, and make a risk and value-weighted decision: if market timing performance does not differ substantially from (or is less than) a buy-and-hold portfolio, and if we risk losing the best trading days by not staying invested, why should we do it in the first place?
As we can see from Exhibit 1, if we consider a very simple buy-and-hold investment in a broad market index like the S&P 500 Index we can see that, over a period of about 90 years, the market has most of the time delivered positive returns to investors. Indeed, by looking at the distribution of the annual returns of the index, the first thing we see is that in the majority of our samples, 69 of 94 (or 73%) times, just holding a buy-and-hold portfolio of a broad market index has delivered positive end-of-year returns.
Looking closer, this plot also tells us another interesting fact: the mean of the distribution is not centered on zero but it is rather tilted to the right, in the region of positive mean returns, meaning that on an annual basis we have more than a 50% chance of ending up with positive returns. In addition, the most frequent observation is a return that belongs to the range of 10 to 20%. In this sense, those findings are confirmed also by noting that the right tail of our distribution (i.e. extremely positive returns) is not only larger (i.e. the S&P 500 never registered annual losses that exceeded 50%) than the left one, but also heavier.
For example, we have had 15 years with returns in the range of +30 to +40% but only 2 years on the opposite side, corresponding to 1937 (i.e. the Great Recession) and 2008 (i.e. the Global Financial Crisis).
Bad Timing Hurts. A Lot.
Just as we found out that a buy-and-hold strategy on a broad equity index can deliver positive returns regardless of timing, we should take a deeper look also at how much timing the market would cost to an investor, from an opportunity-cost point of view.
Indeed, if it is true that there is a potential upside of avoiding or reducing the negative returns that come with a market crash, investors should also keep in mind the tradeoff represented by the limited upside capture of not staying invested when the underlying market rallies. In this sense, as soon as we factor in that the probability of making the wrong call (i.e. being wrong about timing) is very high and that losing out on the best trading days could be a substantial cost that can harm the final return achieved by the portfolio, timing the market becomes a less attractive strategy to follow.
For example, we can compare the long-term performance of a group of portfolios built on the same S&P 500 Index, in which we assume that the cost of timing the market is to stay out of the market during the best trading days in each year. Exhibit 2 shows the performance of such portfolios.
As we can see, being wrong about timing the market can be very costly. In this sense, missing out on the best trading days can be crucial and have a very high impact on the final performance achieved by the same portfolio.
Indeed, during an almost 20-year horizon the fully-invested portfolio achieved an annualized performance of 5.43% while, as we imagine not having been invested during an increasing amount of the best trading days, the final performance becomes -7.56%.
What to Do When Markets Take The Elevator Down
Until now, we have considered market timing in isolation, assuming it is a deliberate investment strategy that an investor could pursue, comparing it with a simple buy-and-hold strategy.
However, timing the market is not always a deliberate choice but often the result of an emotional reaction to extreme market movements.
In this sense, the biggest (and most severe) consequence for investors that unwillingly time the market is to invert the capital appreciation process.
Simply put: they buy when the price is high, and sell when it is low, destroying value by repeating this cycle again and again. Indeed, a common saying in finance says markets take the stairs up and the elevator down. It refers to the fact that while gains take a long time to build up and accumulate, losses can present themselves and hit hard, in unexpected ways.
This asymmetry is particularly important to understand and frame the ideas that emerge from the most recent findings in the field of behavioural finance that – in a line that connects the Nobel-prize winner Daniel Kahneman’s Prospect Theory to Robert Shiller's Irrational Exuberance – have contributed to shed light on the behavior of investors during the unfolding of the economic and market cycle.
The stylized representation of this process is shown in Exhibit 3. As we can see, while the economy expands, it goes through a series of inflating and deflating periods in which the behavioural, economic and market cycle do not coincide perfectly.
In particular, what appears to be critical to understand is the relationship that links those three cycles together.
Most notably, the Market cycle, represented by the dotted green line in Exhibit 3, is the one that anticipates the other two, namely the economic and the behavioural ones.
This result is indeed a typical trait of financial markets: to reflect future expectations of the economic cycle into current market prices.
On the contrary, the Behavioural cycle, represented by the solid red line in the plot, is the last one to unfold, as investors gradually participate in the market and experience different behavioural states that range from the early cycle optimism to the end-of-cycle discouragement, after living a peak of euphoria followed by panic and fire sales. Keeping this stylized representation in mind becomes extremely useful when we do not want to time the markets. Indeed, it is especially in these times that long-term and rational investors must keep their investment process disciplined and not let emotions get in the way of their investments.
Put Time on Your Side
As we build a deeper understanding of the structural and behavioral mechanisms that drive financial markets, we must always keep in mind the reason why we invest, something well-known to any professional investors, asset and investment managers: investing is about protecting and growing capital over time.
In this sense, time seems to be not only the fundamental element of investing but, to a certain extent, the engine that makes the investing machine work.
Indeed, as soon as we shift from a short to a long-term perspective and choose to ride the markets, especially when they get rocky, we see that a scientific and rational approach pays off in the long-term: sticking to the plan, not being impulsive and not destroying value.
Again, there are several reasons that explain why staying invested – the degree of our time in the market – is crucial to build long-term capital appreciation. To a certain extent, we need to put time on our side which, as we will see, has a twofold meaning.
On the one hand, staying invested reveals the benefits of compounding, what Einstein once called the most powerful force in the universe. In this sense, it is the process by which any interest or capital gain is reinvested and accrued to the original principal.
So, like a snowball rolling down a hill, compounding can substantially accelerate the capital appreciation process and contribute to building wealth over time. On the other hand, as we have seen before, if we plan to invest over several market cycles, we become less concerned about the short-term noise and instead strongly focused on capturing the long-term trend of the economy.
This means letting the market cycle gradually unfold to capture the so-called investment factors: persistent drivers of returns that come from a targeted exposure to industry or firm-specific characteristics that can be thought of as an additional compensation that investors require to invest in risky assets.
Eventually, we can use these two components to build a robust and disciplined investment process. For example, if we look at the long-lasting investment career of Warren Buffett – legendary investor and CEO of the 420 billion-dollar conglomerate Berkshire Hathaway – his investment principles totally reflect a patient and factor-oriented approach to build time in the market. In this sense, Buffett’s strategy – known as value investing – is based on the combination of both a long-term investment horizon and a wise selection of each investment, which becomes eligible only if considered “cheap” enough.
This means that, if evidence suggests that a security is currently trading at a discount of its intrinsic value, it should be bought and that, as time goes by, it will converge to its real value thus making a profit.
To see the benefit of long-term investing in action, we can look at the data shown in Exhibit 4. The following plot shows the performance of the S&P 500 Index over different horizons.
The first thing we notice from the above plot is that indeed, as soon as we increase the investment horizon, the red bars that indicate negative returns slowly fade away leaving only the green ones that point out to positive end-of-period returns.
In particular, two additional insights emerge when we look closer at data: the first one is that building time in the market is an efficient choice from a risk-return point of view and the second is that longer investment horizons protect capital in the long-term from short-term swings. Indeed, even if it is true that short-term investors can experience higher returns, they are also exposed to much higher volatility that negatively impacts the efficiency (i.e. the ratio between the average return and the standard deviation) of their portfolios. As a result, from the data collected in the sample, a 1-year investment horizon yields on average an efficiency of 0.46 compared to the 2.23 associated with a 20-year horizon. Almost 5 times more.
In addition, the benefit of investing for the long-term is also related to the ability to protect capital and transfer it through time with better chances of appreciation. Indeed, from the analysis of about 150 years of data, we see that as soon as our investment horizon is larger than 10-years the probability of growing the capital during the investment period is quite high, to the point that when we look at the 20-years window we never see a negative end-of-period return.
Spend Quality Time with The Markets
The previous analysis has outlined the benefits of staying invested through several market cycles and the one associated with a wider investment horizon.
In this sense, a patient approach oriented at keeping emotions and impulsive decisions under control demonstrates not only to be a wise choice but also the efficient one to protect and grow capital over time.
However, we cannot overlook the fact that investing in the financial markets can be rough sometimes and that investors – especially institutional ones – may face several constraints that prevent them from fully exploiting this potential.
For example, often the fiduciary duty of many asset and investment managers requires them to maintain a given asset allocation, volatility and risk target or to limit the losses to a given threshold.
In this sense, the risk that they face is represented by the fact that such constraints would inevitably force them to sell in the worst moment: not only losing the opportunity to remain invested but also extending exponentially the recovery time.
Indeed, having a tight grip on risk management and a dynamic approach to portfolio construction can be crucial in these situations. In this sense, a deep understanding of the dynamics and the impact of volatility on portfolios has a twofold benefit: it allows us, on the one hand, to build robust and well-diversified portfolios that can mitigate volatility during turbulent times and, on the other hand, to constantly monitor and refine their positioning to face a variety of market scenarios.
Besides, as the market cycle unfolds, we can expect the sources of risk to evolve and mutate over time and the portfolio asset allocation to drift.
This points out the fundamental role of dynamically rebalancing the portfolio to keep our positioning in line with the investment objectives but also to reflect a different structure of risk premia and diversification opportunities.
It is by applying a controlled, scientific and diversification-oriented approach based on the analysis of asset correlations (i.e. how assets tend to move with respect to each other) instead of just staying invested that we can achieve a smoother path and, in this sense, spend quality time with the markets.
Eventually, the combined effect of diversification, dynamic rebalancing and efficient risk premia allocation can generate substantial value by mitigating volatility over time. Indeed, reducing the swings experienced by the portfolio not only can contribute to avoiding triggering the above-mentioned management constraints but can also let compounding and time in the market work more efficiently.
Seeing The Bigger Picture
Being able to correctly time the market is a difficult task and may not be as rewarding as it may sound.
On their side, financial markets show themselves not only as complex systems, but are often driven by investors’ irrational behavior.
Most importantly, anticipating them means correctly forecasting their direction. However, when we look at it from an opportunity-cost level, it appears as quite an effort that is hardly paid back in the long-term.
Indeed, the most recent findings in behavioral finance have outlined the existence of different periods that markets and investors experience while the underlying economic cycle gradually unfolds.
In this sense, while the financial markets tend to anticipate and discount future expectations about the growth of the economy, investors tend to be backward-looking and amplify both the periods of panic and generalized euphoria. From this standpoint, instead of actively or passively timing the market, professional investors know well that we need to constantly look at the bigger picture and navigate markets with a disciplined, risk-oriented and rational approach.
In this sense, when we look closer at data, we see that as soon as we increase our investment horizon, short-term noise and market swings are smoothened, and that building time in the market not only delivers positive returns but it has also an attractive risk-return profile.
Nevertheless, staying on the sidelines may not be suited for everyone because of several constraints that especially institutional investors face.
In this case, just building time in the market and being exposed to the weather is not enough and it needs to be enhanced with an additional layer that is centered around three pillars: a dynamic and scientific approach to diversification, a tight grip on risk management and a disciplined allocation to risk factors to efficiently catch market dynamics as they evolve over time.
