Investors suffering during major bear markets are tempted to “time” the market: to sell and avoid the downturn, and then reinvest before the inevitable recovery. It now seems obvious to these investors that anyone with half a brain should have foreseen last year’s credit crisis and massive worldwide fall in asset prices. By selling out ahead they would have preserved their capital and been able to invest this year when stocks are bargains.
Not so, says Javier Estrada of the IESE Business School in Barcelona, Spain. His recent study shows that a small fraction of days determines most of an investor’s gain, and that these abnormal trading days are impossible to predict. “Much like going to Vegas, market timing may be an entertaining pastime, but not a good way to make money,” he concludes.
He studied the impact of so-called Black Swans—the unpredictable tiny minority of trading days encompassing abnormally large upward or downward price swings. The term “Black Swan” comes from the age-old assumption that all swans were white, hence a black swan was considered an impossible event. That assumption was shattered by the 17th-century discovery of black swans in Australia. Black Swans, Estrada writes, lay outside the realm of normal expectations because nothing in the past can convincingly point to their occurrence. They carry an extreme impact. After they occur, plausible explanations can be found for them, making it appear as if they were explainable and predictable, even though they were not.
A prime example is the Black Monday stock market crash of Oct. 19, 1987, when the Dow Jones Industrial Average dropped nearly 23 percent. In the Dow’s 90-odd year history prior to Black Monday, it had fallen more than 10 percent in a day only twice, back in the 1929 crash when it fell by 12.8 percent one day and 11.7 percent the next. Nothing had prepared investors for a one-day decline of 23 percent.
Estrada studied daily returns in the United States and 14 international markets and found that a handful of days of abnormally high or low swings accounted for a major portion of the return to investors in all markets. For instance, in the United States from 1900 through 2006, an investor turned a $100 investment into $25,746 (not counting dividend reinvestment). If an investor missed just 10 days of that 106-year period, he would have cut his gains by an astonishing 65 percent to just $9,008. And yet 10 days accounted for just 0.03 percent of the 29,190 trading days from 1900 through 2006. Even more interesting, an investor who missed the 100 best days during that period ended up making nothing. Those days made up just 0.34 percent of the total trading days and determined whether an investor made any profit or not. It would have been exceedingly difficult to find “the 0.34 percent of the time that determines whether or not any wealth is created at all!”
Estrada wrote. “The odds against successful market timing are simply staggering.” Estrada concludes that Black Swans render market timing a “wild goose chase” and that investors should use diversified portfolios to mitigate their effects and should stick with their investments through thick and thin rather than trying to time markets.
