Have you heard the one about how bad it is to miss the top-performing stock market days? This warning is usually coupled with the standard advice that you should be invested all the time. But the advice is wrong and the warning is simplistic.
The warning goes like this: If you miss just a handful of the market's best days, your portfolio returns will be significantly reduced. For proof, the story comes with a chart that compares being invested in U.S. stocks every single day versus missing a few of those top days.
One version of that chart, using my calculations, shows that $100 invested in the Standard & Poor’s 500, from Jan. 3, 1950 through Feb. 20, 2015, grew to $12,667. Missing the top five days, however, brings the end value to just $8,203, or 35% less. Missing the top 25 days gets a miserable $2,966, or 77% less than just leaving the portfolio alone. The conclusion seems inevitable: It is a bad idea to cash out of the market for any time, lest you miss those crucial days.
As it turns out, this argument is seriously flawed. But because people parrot it over and over, the notion has gained undeserved credibility. What’s wrong with it?
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Certainly, the underlying premise is true: If you take out the best performing days out of any investment, the total return will be lower. What is missing is the explanation for why an investor could possibly be out of the market only during the days when returns were highest, but invested at all other times.
The chance of anyone accomplishing this exceedingly unlucky feat is minuscule. One could just as well say that avoiding a handful of really bad days creates enormous benefits. From a purely random perspective, both scenarios are very unlikely, but equally so because the number of positive days is about the same as the number of negative days.
While missing the best five days reduces this portfolio’s end value by 35%, avoiding the worst five days increases it by 82%. Avoiding the worst 25 days make results soar more than six-fold: you end up with $80,001 instead of $12,667.
Of course, nobody should believe that it is possible to avoid only the worst possible days. Just as unreasonable is assuming that it is any more likely to miss just the best possible days.
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A more realistic scenario is this: What would happen if an investor misses both extremes? Tally the end value of the S&P 500 without its eight best and seven worst days, which is roughly the ratio of positive to negative days. The nice little surprise is that investors are better off missing both the highest and lowest return days than being invested at all times. This is true for multiples of that eight-to-seven ratio as well.
We can draw two lessons from this. First, the myth that being out of the market for a minuscule timespan carries a serious risk is flawed. Institutional asset managers with an incentive to keep everyone invested at all times are quite vocal at propagating this story, which is understandable: that’s how they are paid.
Second, there may be an advantage to be in and out of the market than to be invested at all times. But let’s examine this idea closely.
On one hand, when investors try to time the market end up, they often doing worse than if they remain always invested. The reason is that most people suffer from behavioral biases that lead them to making the wrong decisions.
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Many times, for example, investors carry losing positions far longer than they should because they want to avoid the pain of booking a loss. The result is larger losses than if they had set an exit threshold in advance, such as a loss of 10% or 15%. We all know someone who lost 50% or more of his or her portfolio during the financial crisis before cashing out just as the market touched bottom and started going up again. The tendency to let losses run is responsible for many portfolio disasters.
On the other hand, a strong argument exists for adopting a systematic approach to asset allocation, designed to deal with those investor shortcomings. This approach is at the core of my firm’s investment strategy.
Using clear rules of exposure can go a long way toward avoiding the mistakes made when emotions drive investment decisions. Fear of loss, impulsive buying or selling, or drawing conclusions from a single event are well-known decision-making problems. Still, investors regularly fall into those traps.
To be fair, creating a dynamic strategy is not easy. This may well be why simple stories like the “be invested at all times” are so appealing. Following rules of thumb is much easier. But gross simplifications that ignore the complexities of market behavior can be useless and sometimes quite dangerous. Investors should ask their advisors to help them cut through the fog of fairy tales.
This article originally appeared in AdviceIQ.
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