The Cost or Benefit of Time Out of the Market

I don’t know if you’ve ever heard it before, but there have been studies done with the intent to help folks realize the benefit of remaining invested in the market… with the outcome being if you missed the ten best days of the market’s returns over a particular period of time, your overall results are significantly diminished.

I’ve always been intrigued by the concept of these studies, so I decided to undertake a similar study of my own, using a few different circumstances in order to hopefully reflect what might happen in real life.

The Study

I used S&P 500 data to represent the stock market, and for the sake of better understanding and applicability to the present, I have limited the data used to the time period of January 1990 to present.  In order to better represent what most folks would do in real life, I used monthly results, rather than daily – because I figure that most folks, if they change a position (i.e., sell out of stocks, for example), most likely they would not jump right back into the same position the next day.  I figured 30 days was a little more realistic of a timeline for making changes to your holdings.

Also, I did not include dividends in the analysis, although these can be a significant part of your returns.  It was much simpler to work with the actual returns, rather than try to estimate when dividends might be paid and whether or not you were currently invested at that time.  I figure the results would be very similar, either way.

Lastly, transaction fees and taxes have not been factored in to these calculations.  Depending upon the circumstances these two factors can have a drag on your results – but taxes won’t come into play in an IRA, for example, plus transaction fees may not apply to your case.  In addition, if you’re working with traditional mutual funds, sometimes there are repercussions to changing your position frequently – such as holding periods.  These have also not been factored into the results.

Results

For the long-term benchmark, I assumed that the investor made an investment in January 1990, and left it alone until the end of September, 2010.  If you did this, you would have seen a total return of 230.05% – that’s a simple average of 11.5% per year.  Now we’ll start making some assumptions to change things up a bit.

What happens if we got out of the market for just one month during that twenty year period?  If we did this and happened, just by chance, to miss the month during that period with the best return of all of them, we’d have reduced our overall return to 194.63%. The month was April 2009, if you wondered, and the return was 12.02% for that month.

On the other hand, what if we were extremely lucky and missed the very worst month during the period?  (October 2008, at -20.39%, in case you were wondering.)   That would result in an overall result of 314.59%, or an average annual increase of more than 4%!  But how in the world can you guess that you’ve got the right month?  The very best month and the very worst month in 20 years were only six months apart…

Here’s another option to consider: what if you took two months out of the market during the 20 year period?  If it was the best two months that you missed, you’d drop your overall return to 164.73% (the second-best month during the 20 years was February of 1991).  But if your timing was immaculate and you skipped the two months in the 20 year period with the worst possible returns, you’d boost your results to 367.72% (the second worst month was September 2009).

Lastly, I took the data and calculated what would happen if you had the worst luck of all and missed the 10 best months during the 20 years studied… your result would be a paltry 46.45%, only 2.32% per year.  On the other hand, if you had near-perfect timing and happened to miss out on the ten worst months of the period – you’d have pulled down a total return of 816.90%, a yearly average of 40.85%!!  Clearly it would benefit you to have a crystal ball.

Add In Human Nature…

Since one month is a very short period of time, I took the same data and calculated what would happen if you not only missed the months in question, but then you also delayed an extra month before getting back in the market.  Here are the results under those circumstances:

Missed best month and the month following: 176.92%
Missed best two months and the months following: 142.11%
Missed best ten months and the months following: 25.06%
Missed worst month and the month following: 354.85%
Missed worst two months and the months following: 397.91%
Missed worst ten months and the months following: 943.74%

Clearly, once again, it pays to have had a degree of clairvoyance working in your favor.  But obviously you can’t plan to have this kind of timing – so far I think we’ve learned that staying the course has benefits.  Although it would be pretty cool if you had hindsight working in your favor and could miss all those bad months, the likelihood of hitting it just right is pretty low.

What About Reacting?

So – since we don’t have a crystal ball available to us, what’s the next most obvious way to handle things?  Reacting, of course.  So I took the same data and ran the calculations based upon those same months, only instead of missing the best or worst, you missed only the month following the best or worst months, in reaction to the prior months’ results.  Here’s how that turns out:

Missed the month after the best month: 210.21%
Missed the months after the best two months: 201.86%
Missed the months after the best ten months: 164.90%
Missed the month after the worst month: 262.10%
Missed the months after the worst two months: 251.36%
Missed the months after the worst ten months: 312.20%

This shows us that there may be some benefit to be had by taking the reactionary stance – for the worst ten months example, you’d have improved your overall return by over 80% for the period, more than 4% per year. But how would you know if you were choosing the right 10 months to react to?

The other thing that this shows us is that reacting to a positive result by locking in your returns and standing pat doesn’t help – I suspect that the momentum of the market is working for both cases.  This means that, if the market is on the rise, more often than not, it will continue to rise in the following month, and vice versa.

Practical Application

Since we don’t know for sure what the best and worst months will be in advance, what if we used the prior month’s return against a benchmark result and then reacted by getting out of the market for the following month?

On the upside, once again, locking in your positive results in any month with better than a 4% return (an arbitrary number that I chose), you’d wind up with a result less than half (at 111%) of what you’d have gotten by just buying the market and staying in it for the full period (which was 230%).  There were 32 months in the 20 year period that met this criteria.

The market momentum once again works its magic (at least with the data I used). If you chose to get out of the market on the first day of any month following a downside month (of which there were 97 in the period studied), you would have wound up with an overall result of 355.93%.  This is a good thing!  By putting this easily-understood method into play, your overall results increased by better than 6% per year.

Keep in mind that the study only covered the previous 20 years – a relatively small period of time, with some pretty dramatic results, both positive and negative.  I’m going to do some further study on the historical data and I’ll let you know more about those results after I’ve done that analysis.

Even with that fact in mind, I think this might be a useful tactic to consider putting into place.  I still think that the core of your portfolio should be left in place for the long term – especially with your well-balanced portfolio.  But it could work in your favor to put such a plan into place for a small portion of your portfolio, such as maybe 10-20% of your domestic stock holdings. The critically important fact here is that for this to work you have to stay disciplined and make your moves at the correct times.  Otherwise this won’t work.

And if you don’t want to hassle with this kind of manipulation, it’s still pretty clear that you can definitely do worse than the long-term hold tactic, which is the simple, tried and true way to handle your portfolio.

Photo by Spencer C. Curtis