Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

The Hidden Cost of Market Timing

November 2009

Volatile markets are especially dangerous for investors as they often lead to dramatic changes in an individual’s willingness to assume risk, causing those who would normally embrace a buy-and-hold strategy to engage in market timing. When stressed investors are contemplating bailing out of the market, most willingly admit that they won’t be able to make a perfect call on the market’s bottom or top, but believe they can get “close enough” and view any lost return due to a timing mistake as negligible.

This cost, however, is usually massively underestimated, especially for those individuals who consider themselves to be long-term investors.

The real cost can be shown with simple math. For example, below is a chart showing the weekly percentage gain or loss in the S&P 500 index from January 1, 2009 through November 3, 2009:
 
The chart shows the S&P 500’s best weekly return over the measured time period was March 9-13, when it gained 10.79%. Not coincidentally, this was the first week following the market bottom on March 9. From that point through November 3, the S&P gained 55.14%.

Now consider an investor who was out of the market and missed only the first week of the recovery before jumping back in.  Though most investors would be impressed and quite satisfied with the 40.03% subsequent gain from March 14 through November 3, this is actually 15.11% less compared with someone who was fully invested in the S&P 500 for the period.

So how does missing out on the first week’s return of 10.79% end up costing the investor 15.11%? Where did the additional 4.32% come from? The answer lies in the simple beauty of compounding.

Consider two hypothetical investors, one who was fully invested the week of March 9 with a $100,000 investment, and another who waited a week and then put the same $100,000 into the market the week of March 16.

 

 

Intial Investment
March 9

Return
March 9-13

 

Ending Investment
March 13

 

Ending Investment
Nov 3 

 

Portfolio Growth
March 14-Nov 3

Invested

 

$100,000

 

10.79%

 

$110,790

 

$155,139

 

$44,349

 

Not Invested

 

$100,000

 

0.00%

 

$100,000

 

$140,030

 

$40,030

 

   

Difference

$10,790

$15,109

$4,319

As you can see, the first investor, who enjoyed the 10.79% gain the week of March 9, began the following week with $110,790, while the second investor who waited a week to get back in the market began with the original $100,000.

From that point through November 3, though both investors’ portfolios compounded at the same rate, the fully invested individual was compounding an initial larger amount. The extra $10,790, compounded at the portfolio’s rate of return from March 14 through Nov 3, 2009, grew to $15,109 at the end of the period. This explains the additional 4.32% the buy-and-hold investor enjoyed and is a very real part of the opportunity cost the market timer incurred.

Opportunity costs will only increase over time as missed returns will never have the chance to compound. At the end of 10 years, assuming an 8% return, the original $10,790 mistake grows to $23,297; at the end of 20 years it grows to $50,291, and after 30 years the cost to the investor is $108,576 and we haven’t even factored in the costs of more frequent transactions or the earlier recognition of capital gains the market timer will also incur.

As you can see, timing mistakes are not simple rounding errors. They result in very real dollars lost that investors will never get back, and the opportunity cost of missing those gains will only grow to ever greater amounts over time.

Investors have two choices: They can either choose to stay invested and be 100% assured of capturing the market’s return, or they can engage in market timing, which not only has a lower probability of capturing the market’s return but will also continually compound errors over time.

Email A Friend Print This Article