Market Timing: The Importance of Doing Nothing

The headlines scream at us relentlessly from our computers and phones, seemingly begging us to engage in market timing. "This market looks just like 1998," says one. "JP Morgan's market guru says his 'once in a decade' trade is upon us," blares another.

The advice grows more strident when the market turns volatile.

It's remarkably difficult to pick a good mix of stock and bond funds – then avoid making big changes to it. But you should. In fact, on top of my to-do list, so I can't miss it, I have six words typed in big, bold letters:

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"Don't just do something; stand there."

The Perils of Lousy Market Timing

"Timing is the bane of investors everywhere," says Russel Kinnel, director of manager research at Morningstar. "Bad timing can cost you dearly. Everyone from new investors to administrators of giant pension funds and fund portfolio managers makes these errors."

Want proof? Kinnel and his colleagues calculate "investor returns" for mutual funds and exchange-traded funds (ETFs). In essence, their research illustrates the drag of lousy market timing by showing how the average dollar invested in funds did versus the total return of the funds.

The average dollar earned 45 basis points less on an annual basis over five 10-year periods through 2018. (A basis point is one one-hundredth of a percentage point.) Investors in stock funds lost 56 basis points to bad timing, investors in bond funds lost 55 basis points and investors in alternative funds lost 1.44 percentage points annually, according to the Morningstar study.

That investors lag bond-fund returns almost as badly as they lag stock-fund returns is surprising, given that bond funds typically are less volatile than stock funds. But also note the relative size of the gap. Stock fund­s averaged 6.8% annual gains versus 3.4% for bond funds, which means market timing took a larger bite out of bond returns as a percentage.

Alternative funds, meanwhile, are extremely complex investments that often produce low returns and have low correlations with both stocks and bonds. Those factors make them difficult for investors to understand – and easy to dump when they underperform, Kinnel says.

Then there are allocation funds. Investors in allocation funds actually topped the performance of the funds they invested in, by 22 basis points. Why? Be­cause many allocation funds are target-date retirement funds. These funds are designed for investors to hold over an investment lifetime. They're a mix of stocks and bonds that gradually becomes more conservative over time. Plus, the overwhelming majority of target-date assets are in 401(k)s and other work-based retirement vehicles that make it easy for employees to contribute monthly using dollar cost averaging.

How Can You Avoid Bad Market Timing?

Morningstar's study offers some help – in addition to the admonition not to trade too much.

It turns out that the more volatile a fund is, the more likely investors are to buy and sell it at the worst times. That makes sense. It's far more difficult to hold a fund that's losing a ton in a bear market than one that's taking a hit but isn't down as much as the overall market.

Kinnel breaks stock funds into quintiles from most volatile to least volatile. Investors in the most-volatile quintile lagged their funds by 1.86 percentage points per year. Ouch! Investors in the least-volatile quintile lagged by a mere 19 basis points.

"Boring funds are working well for people as they don't inspire fear or greed," Kinnel says.

Performance by expense ratio is similar to volatility. The average dollar in the cheapest funds lost less to market timing that those in costlier funds. Investors in the lowest-cost quintile of stock funds trailed their funds by 1.1 percentage points per year. Investors in the highest-cost quintile of stock funds lagged by 2.2 percentage points annually.

Kinnel notes that lower-cost funds tend to do much better than higher-cost funds. "Costs are good predictors of performance, so this makes intuitive sense," he says in the study.

"A second factor in good investor returns might be that low-cost funds attract savvier planners and individual investors who make better use of their funds."

Kinnel has been performing these studies for many years now. What's encouraging is that the gap between investor returns and fund returns has slowly but surely been narrowing over the years.

Perhaps we are getting a little smarter.

But we've also been in a very long bull market. It's going to be much more difficult to stay invested the next time the market tanks.

"When markets lurch, investors do worse because they make timing mistakes," Kinnel says. "Investors large and small tend to sell after downturns only to buy back in after rallies."

Being mindful of this could steady your hand and help you avoid that fate.

Steve Goldberg is an investment adviser in the Washington, D.C., area.