The Simplest Reasons Why Time In The Market Beats Timing The Market

it's long been understood by financial experts that for the vast majority of investors time in the market is going to beat timing the market at least over the long run whether this is because picking winning investments over an extended period of time is incredibly difficult which statistically speaking it is or because our emotions get the better of us at an inopportune moment or simply because the realities of the cost of doing business as an investor gets in the way this has long been the conventional wisdom but beyond almost all of those common and valid explanations are two other arguably far more simple explanations that i rarely hear discussed and that's what we're going to be going over today let's discuss two of the simplest reasons why time in the market will almost always be trying to time the market over the long term for ordinary investors but before we get going be sure to like this video if you haven't already as it really does help out the channel a lot and subscribe with notifications on for more money related videos like this one every single week and if you want to further support this channel you can check out some of the links i've left in the description below which includes a link to the investing platform m1 finance get started investing for free today some of the most common arguments for why timing the market tends to not work for most investors over the long run are that you can erode most or even all of your gains by missing out on one prediction your emotions can get the better of you at an inopportune moment you miss out on some dividend income during the portions of the time that you're out of the market and depending on your specific situation you may incur some substantial investing related costs such as capital gains taxes regular trading costs and potentially costs related to specific investing strategies that you choose to put your money into like those associated with trading options missing on predictions makes sense it's something that we all do from time to time even if we're just simple buy and hold investors who are just predicting where we think the markets will go for the sake of it but as active investors those costs can be quite substantial it's where most of the potential gains are to be had after all for instance those people who were trading actively and failed to get out of the market before the onset of the great recession of the late 2000s could have lost 50 percent or more of their money based on the performance of the s p 500 from 2007 to the bottom of the market in 2009. even for those who did manage to avoid that crash it's possible that some of them would have been spooked by the downturn and as a result did not get back in until the markets had recovered a few years later in 2013. that type of miscalculation was also costly to the tune of about 19 per year and potential gains on the emotional side of things what about those people who succumbed to the greed of the dot-com boom they weren't wrong in terms of their predictions tech stocks did fantastically well during that era at least until the bubble popped and even today some of our biggest companies are from the tech space facebook google apple microsoft amazon the list goes on so the predictions weren't wrong it's just that in some cases emotions can get in the way of sound long-term thinking the nasdaq which is a little heavier on tech stocks than the s p 500 gained about 40 percent per year from 1995 through 1999 or about 540 percent in total so that gives you a general idea of what a broad-based but still reasonably well diversified tech-heavy approach produced during that era however some of the top tech stocks like qualcomm cisco and microsoft posted returns of approximately 6 twenty 200 hundred and fifty percent and fourteen hundred percent respectively during that same time frame that's quite a substantial gap between them and the market as a whole and in an era where it seems like you can do no wrong by investing in any startup tech company that goes public you can understand why a lot of people gave up on the diversification benefits of a more broad-based index fund in favor of investing in single stocks in the technology space for some of them it worked out phenomenally well for others they sunk most or all of their money into pets.com and eventually went bust the point is you don't have to make a wrong prediction to see your returns come up short when trying to time the markets the possibility of lost dividend income over time can also make quite a substantial difference particularly if you're spending a lot of time out of the markets for instance since 1930 around 40 percent of the s p 500's total returns have come from dividends according to research done by hartford funds s p global puts that figure at around 32 since 1926. either way that percentage is a noteworthy amount even if it has been a little bit lower in recent years think about an investor who was trying to time the market and spent roughly half of their time with their cash on the sidelines waiting for an opportune moment to buy that suggests that roughly 15 to 20 percent of their overall growth would have had to have been made up for with successfully timed trades that's certainly theoretically possible but it's quite difficult to do especially over such a long time period and of course the costs of trading always have to be considered bid ask spreads or the difference between the highest price that a prospective buyer is willing to pay for a share of a stock and the lowest price that a share owner is willing to sell a stock for at any given moment on highly traded assets like your most popular s p 500 index funds might only be a few pennies a share in other words for most everyday investors it's pretty negligible however if you're trading in less liquid assets such as many individual stocks the bid-ask spreads can be quite a bit wider and thus add up to significantly higher costs over an investing career assuming you aren't doing this investing in some sort of tax advantaged account you do have to factor in things like capital gains taxes which could be as high as your ordinary income tax rate if you're trading and realizing gains regularly or could be calculated at the more favorable long-term capital gains tax rates which at least at the time of this writing caps out at around 20 and as we just went over with the dividend example that can be quite a hurdle to overcome through successfully timed trades alone as i said all of these common explanations are valid but there are a couple other potential reasons for it that i don't often hear mentioned and those reasons are that assuming you're investing primarily in broad-based assets like most everyday stock market index funds and you're unable to consistently avoid market downturns market timing struggles over the long term relative to buy and hold investing because there just isn't that much to be gained from it in the first place and because the gap between what you could potentially gain by successfully timing the market is not all that much more than the price you pay to play the game let's put some numbers to these ideas to show you what i'm talking about first we'll start with the idea that there may not actually be all that much to gain if you can't avoid market downturns let's go back to 1980 and we'll say that john and jane are both investing in a simple s p 500 index fund however while jane is going to be taking a simple dollar cost averaging buy and hold approach with her investments john is going to be timing the market thankfully for john he has been blessed with the powers of an investing god he's not just going to try and time the market he's going to succeed in fact he's going to invest his money on the day where the market bottoms out each and every month so in other words he'll never make a wrong prediction his emotions will never get the best of him we'll assume that he's investing in a tax advantage account and doesn't lose any money on bid ask spreads or any other type of investing expense the only thing he might miss out on are a little bit of dividends for the shares that he may not have bought yet in the months when dividends are paid i'm setting up the scenario in this way not because it's even remotely realistic because it definitely isn't but because i wanted to see in a hypothetical perfect world or at least near perfect since we're not actually having john's sell as investments before every market downturn how much could an investor potentially gain by timing their contributions successfully over an extended period of time as it turns out the answer is not much these charts show the average ending net worth figures for john and jane during every available start month assuming they invested the equivalent of five dollars a day into the markets over 1 5 10 and 20 year time periods from january 1980 to august 2022 as you can see while john does come out ahead more often than not thanks to his godlike market timing abilities it's usually not by all that much even over a 20-year span it typically comes out to less than a couple grand what this means is that the vast majority of potential gains that you can get from timing the market comes from selling at or near market highs and then subsequently buying at or near market lows in other words avoiding market crashes but that brings us to our second reason the cost of playing the game is often pretty close to the realistic payouts you could expect to receive from winning it let's look at what would happen if jon had managed to avoid major market crashes if jon managed to sell his investments just before the markets tanked in 1980 1987 2000 2008 2020 and 2022 as those are the biggest market downturns during this time frame and then he managed to buy back in the day the markets bottomed out following each of those downturns how much better off would he have actually been before things like taxes and investing costs are factored in as it turns out quite a bit as i'm sure you'd imagine by my count assuming no taxes or other trading costs to speak of an investor who perfectly timed their trades on both the sell side and the buy side for each of those associated downturns would have grown their nest egg to nearly 8.65 million dollars assuming regular contributions of five dollars every trading day that's about 10 times the net worth of a simple long-term buy-and-hold investor during that same time frame who would have amassed about 823 000 however in the real world taxes are a thing again assuming you aren't trying to time the market in a tax advantaged account exclusively which for most of us would be an unwise move since we need that money to grow reliably so that it's there for us when we can no longer support ourselves when you factor in those costs the gap is still highly impressive but not nearly as impressive as 8.65 million dollars because in order to avoid market crashes you either need to be implementing some type of short selling strategy which costs money to implement or you need to be out of the market in other words you need to sell and realize your gains regularly meaning that a sizable chunk of john's nest egg would have regularly been taking tax hits of 15 to 20 or more assuming an average capital gains tax rate of 15 which would have been where john would have spent most of his time in this hypothetical due to the massive amounts of gains he'd be realizing with the majority of his sales his ending net worth would have fallen from around 8.65 million to 5.26 million still massively impressive but we're talking about a guy who perfectly timed both ends of his trades every time for over 40 years with no missteps what if he missed on just one of those predictions or slightly mistimed one of them how would that affect the figures let's see if john mispredicted the downturn of 2020 since while it was more severe than some of the downturns we've considered today it was also fairly short-lived at least in the markets so it won't keep john out of the markets for very long his net worth would have fallen from around 5.26 million dollars to around 3.77 million dollars less than half of what he would have achieved in a perfect world if john missed the mark by just one day following the flash crash of 1987 in this case buying back into the markets on friday october 16th 1987 instead of the following monday his net worth would have fallen further to around 3.24 million dollars beyond that what if john sells his investments in anticipation of a crash that never comes that's something that countless investors do every single year but it's quite problematic for john because not only would he then be taking a 15 tax hit for nothing but he'd also miss out on market gains for however long it took him to realize his error and jump back into the markets just to put some numbers to it let's say that jon sold at the start of 2017 because he assumed that after nearly a decade of strong growth the party had to end some time as many people fought at the time he stayed out of the markets for that entire year before buying back in at the start of 2018. in this scenario john's net worth plummets down to about two and a half million dollars again that's still basically triple what the buy and hold investor achieved but keep in mind just how well things had to go to get here with one loan exception john perfectly timed his trades by both cashing in at the absolute peak of the market and buying back in at the absolute bottom of the market he only miscalculated the direction of the markets once in his four decade long investing journey and only failed to avoid one notable market crash additionally he only ever sold when the markets were entering periods of major turmoil which allowed him to space out the realizing of his capital gains enough that he never had to pay short-term capital gains tax rates which kept his effective tax rates quite a bit lower than most active traders actually experience in the real world ask yourself what are the odds of all of that happening in reality so there you have it market timing if done exceptionally well can in theory produce far superior returns to a buy and hold investor that was never really in dispute but that advantage can narrow pretty quickly with every missed prediction or mistimed trade this is largely because a week early or a week late on a trade during highly turbulent times which market crashes and the lead-ups to them tend to be can make a huge difference in the net gain that you realize as an investor as we saw in the extreme example of 1987 and the difference between the effective tax rate you'd pay on the gains and the amount the markets typically drop during downturns is not actually as large as you might think especially when missed dividend income and other potential trading costs are factored into the equation so in order to build up a wide gap between an excellent market timer and a buy and hold investor you generally need to string together several spectacularly timed trades in a row over an extended period of time beyond avoiding market downturns the value of trying to time the market in other ways such as through when you make your contributions tends to not produce very impressive results even when you do have perfect accuracy because at least for those of us who are investing in more well-diversified broad-based investments there usually just isn't that much room to be gained in that area of investing but that'll do it for me today once again if you enjoyed this video be sure to smash that like button if you haven't already subscribe and hit that bell next to my name so you'll be notified of all my future uploads i generally upload every single monday and if you have a friend that would be interested in this kind of content be sure to share it with them let's really get this information out there and start our own financial revolution

Channel: Next Level Life

Views: 11,035

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Id: 8M9vkcVZOTs

Length: 14min 25sec (865 seconds)

Published: Mon Feb 06 2023