With the stock market’s recent volatility, now may seem like a good time to take profits and wait on the sidelines until the proverbial dust settles. After all, the bull market has persisted for nearly 10 years, the US Federal Reserve continues to raise rates, and global economic growth is decelerating (albeit modestly). Throw in an ongoing trade war and pockets of political turmoil, and taking profits may seem like a sensible strategy in these uncertain times.
And yet, we’d argue that much of that bad news is already priced in. US equities have “corrected,” down approximately 10% from their peak (but still flat for the year), with many stocks down a lot more. This has all occurred while 2018’s earnings have been robust, making valuations a lot less expensive than the beginning of this year. Specifically, price-to-earnings multiples for US large-cap stocks are down nearly 20% this year with small-cap and international stocks down even more. Therefore, what is arguably not priced in is the good news; unemployment is low, consumer spending is healthy, consumer balance sheets are sound, and company earnings are growing near-double digits.
This push and pull of market drivers has many investors uncertain as to what to do and considering selling their stocks until the picture is clearer. However, trying to time market moves to mitigate risk and improve your well-being could backfire, coming at the expense of meeting your financial goals over the long run. Here are three major reasons why we believe market timing is a poor long-term decision.
Emotions Get in the Way
There are several factors working against investors trying to time the market. The first is psychological.
Let’s say you decide to cash out. At some point you’ll have to buy back in, right? On the one hand, the market could continue falling as the landscape worsens, thus discouraging most investors from buying back in. But that’s exactly what you’re supposed to do—repurchase at a lower level, sidestepping the incremental downside by doing so.
On the other hand, markets could unexpectedly rally after your sale. You’ll be kicking yourself for being on the sidelines, while the missed appreciation may cause you to wait for another retreat back to your sale price—a retreat that may never come.
The point is, during volatile periods, no one knows with a high degree of confidence what the next month (or even six months) will bring. A steep fall or a big rally is equally likely. But as we look further out, over a year or more, we know that markets often recover from seemingly bad news in a reasonable amount of time for long-term investors.
Even if you can overcome your emotions, the next factor further lowers your odds of success.
Missing the Best Days Is Costly
Understanding how returns are generated is key to any attempt to time the market successfully. We ran the numbers going back nearly 30 years, and they showed that a year’s return is often generated in only a handful of days. Meaning, returns come in bursts, and if you miss one, your annual return pays the price. All the other days basically net out to 0%.
According to our analysis, missing the best five days over any three-year rolling period significantly reduced an investor’s performance, essentially turning long-term stock returns into bond-like returns (Display 1). Missing the best nine days over the same period turned profits into losses.
What’s the takeaway? Missing out on the market’s best days, which could easily happen while sitting on the sidelines, could severely diminish the return due to an investor’s market timing attempt.
Taxes: Yet Another Hurdle to Clear
While market timing is hard enough, taxes raise the hurdle that investors must overcome to profit from such a strategy. When you exit the market, you end the deferral on any taxable gains and pay a capital gains tax.
This sets up a daunting challenge. The more taxes you pay upon exit, the lower your reentry price must be for the strategy to be profitable since you’ll have less money working for you in future years. In other words, taxes make the hurdle for selling equities that much higher.
Think about it this way. Taxes due on unrealized gains essentially represent an interest-free loan from the IRS. Pulling forward the realization of those gains by liquidating stocks means giving up the compounding effect of that attractive loan. The impact of this can be highlighted through a simple example.
Assume a $1 million portfolio with $500K of gains and 30% total capital gains tax rate (both federal and state). Realizing those gains today would generate a $150K tax hit or 15% of the market value. A lower or higher cost basis would increase or decrease that tax hit. Accelerating that gain now means 15% less money working for you in the future. And while an investor would have likely realized some of those gains in the coming years anyway, it certainly wouldn’t have been a full realization as quickly, thus giving up the compounding effect of the embedded gains.
Our Solution? Trust but Verify
Enduring occasional setbacks has always been the price of long-term growth. A good investment plan assumes such setbacks: both in bull and bear markets, and during both calm and volatile periods. We continue to believe returns will be more modest over the foreseeable future, but not poor.
As investment advisors, our goal is to work with clients to develop diversified asset allocation plans that incorporate our outlook, are tailored to the client’s unique objectives, and importantly, tailored to that client’s risk tolerance. Having any degree of risk tolerance means being able to deal with occasional volatility.
While it can be hard to stay committed to a long-term strategy in today’s market, history strongly suggests it’s the best course of action and significantly increases the likelihood of long-term success relative to the alternative. Where appropriate, we reexamine asset allocations during volatile times to ensure they are consistent with a client’s needs. Most often, the market’s short-term risk does not derail the client’s long-term likelihood of success, which makes market timing an unnecessary, and ironically, risky endeavor.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.