If you keep $100,000 of your portfolio out of the market, you could be costing yourself almost $200 per day.
Now that I have your attention, if you're like every other investor -- and I do mean "every," with myself included -- a question that you continually grapple with is whether you should have your money invested or if you should wait around for a time when the stock market and global economy look more inviting. With the 2008/2009 recession flashing brightly in the rearview, it's completely natural to wonder whether now is the right time to invest or whether you'll just be stepping in front of an oncoming freight train.
The problem with that question, though, is that it's terribly short-sighted.
Trading places, randomly
When we ask ourselves the question of whether or not we should be investing right now, we should be asking ourselves simultaneously if we have the foresight to know how markets will move over the short term -- months, weeks, or even days. If we don't, then when we decide to invest on a particular day or not invest on a particular day, we're essentially doing it at random.
I hate to be the one to break it to you, but most research points toward exactly that conclusion. When investors try to time the market, they tend to lose. At the risk of oversimplifying some of my favorite research on the topic -- Brad Barber and Terrance Odean's "Trading is Hazardous to Your Wealth" -- the two researchers sifted through reams of data and found that those retail investors that trade most get below-average results. The timing of their trading ends up just being random and not actually adding any meaningful benefit, while transaction and other costs eat away at their returns.
A little experiment
Last week I downloaded around twenty years' worth of S&P 500 (INDEX: ^GSPC ) price data, set up some fancy Excel calculations, and spent the afternoon playing around with the spreadsheet.
"What happens," I thought to myself, "if I was out of the market for a random 200 days -- or an average of around 10 days per year -- between 1991 and the end of last year?"
I ran the simulation 50 times -- each time generating a different 200 days where my theoretical savings was not invested in the S&P. The results looked like this:
|Actual S&P 500 return 1991-2011||285%||285%|
|S&P 500 return excluding 200 trading days||262%||246%|
|Percentage over/(under) performance of random condition||(23%)||(39%)|
|Ending portfolio value difference on $100,000 portfolio||($23,301)||($39,331)|
Source: YahooFinance; author's calculations.
Focus in on that last row. What it says is that at the end of the 20-some years I looked at, your account would be almost $40,000 lower if you were out of the market for just 200 trading days. Break that down to each trading day that your money was sitting on the sidelines and you get $197 for each and every day.
Since I wasn't yet sufficiently bored by running and rerunning random scenarios, I went through the exercise again, this time taking out an average of more than 1,100 days over the 1991-2011 stretch. Predictably, the shortfall amplified. This time, at the end of the period, that $100,000 account would, on average, end with a whopping $93,604 less than if the money had just been kept invested through the entire period.
I've used the S&P 500 here, but I can guarantee you that you'd get pretty much the same result if you did the same thing for the Dow Jones Industrial Average (INDEX: ^DJI ) or the small-cap Russell 3000 (INDEX: ^RUA ) . Why? Because the answer that my spreadsheet spit out was painfully obvious even without the Excel acrobatics.
The very meaningful "duh" result
As noted in the table above, the S&P 500 was up 285% between 1991 and 2011, or about 6.6% per year (this doesn't include dividends). Because the index was moving up, up, and up over time, taking out random trading days should lower the result most of the time. And the more days you take out, the lower that result goes. The reason that we know we'd get the same result from the Dow is that it rose 368% over the same stretch.
Now we can put the pieces together:
- It's highly likely that trying to trade in and out of the market based on timing is going to be little more than an exercise in buying and selling randomly and racking up transaction fees.
- If the market goes up over time, being out of the market at random intervals will very likely do nothing more than lower your end result -- that is, cost you money and maybe a lot of it.
The big question you should be asking yourself, then, is this: When I look out 10 or 20 years into the future, do I think the market will have posted an acceptable average annual gain?
If the answer is "yes" then you've gone ahead and answered the supposedly tricky question that the article title posed.
Notably, this same idea works exactly the same way for individual stocks. Take General Electric (NYSE: GE ) for example. Great company, builds things the world needs, and has been doing that for a long, long time. Should you buy the stock today? It's the same process: Do you think that 10 or 20 years from now the average annual gain will be attractive? If the answer is "yes," then trying to perfectly time your purchase is likely to be a costly move.
Of course GE isn't the only stock that might be a great long-term play. My fellow Fools have identified three Dow stocks that they think belong in your portfolio. To find out which three, download a free copy of the special report "The 3 Dow Stocks Dividend Investors Need."