Taken from the Motley Fool's Newsletter released on Friday:
September 2007 Issue: Page 10 of 10
Fool's Tools: Don't Try to Time the Market
By Rich Greifner
Many Stock Advisor subscribers likely are familiar with the old Wall Street adage, "sell in May and go away," a strategy that attempts to exploit the historical trend of poor market performance during the summer months. There's just one tiny problem with that rule, as well as nearly every other market timing strategy: It doesn't work.
According to the Stock Trader's Almanac, a strategy of investing in Dow Jones stocks during the "good six months" of the year (November through April) and switching to fixed income securities during the "worst six months" (May through October) would have grown an initial $10,000 investment into $544,323 over a 56-year period. Meanwhile, the opposite strategy -- which I will dub, "sell in November and hope to remember" -- would have lost money over the same period. So why don't we endorse this approach?
Next Stop ... Bangladesh!
"Sell in May" is hardly the only market-timing strategy that can demonstrate above-average returns by manipulating historical data. There's the Super Bowl predictor, the Presidential Election cycle, and my personal favorite, the Hemline Indicator, which ties stock market performance to the length of women's skirts (naturally, shorter is better).
But before you break out your ruler at the local Ann Taylor, remember that these market-timing theories rely more on correlation than causation. Armed with historical data and a powerful computer, an enterprising investor can establish a link between stock market performance and just about any real world event. Need more proof? Cal Tech professor David Leinweber found that, historically, the single best predictor of the S&P 500's performance was butter production in Bangladesh. Are you willing to bet your financial future on the cows in Chittagong?
So You're Saying There's a Chance?
While the recent stock market volatility illustrates the enormous potential gains from market timing, most experts agree that jumping in and out of stocks is a recipe for disaster. In 1975, Nobel laureate William Sharpe concluded that "attempts to time the market are not likely to produce incremental returns of more than 4 percent per year over the long run." Sharpe concluded that unless a market-timer could accurately forecast market conditions 70% of the time, he was better off with a simple buy-and-hold strategy.
The adverse effects of market timing can even negate the returns of a master investor. Although the Fidelity Magellan Fund raked in astounding 29% annual returns during manager Peter Lynch's 13-year tenure, individual investors didn't fare as well. Lynch believes that most Magellan investors actually lost money over that period by jumping in when the fund was hot and pulling out when things cooled off. Individual investors tend to buy high and sell low -- not an optimal investing strategy.
Statistically speaking, investors' returns suffer when they stash assets on the sidelines. Consider that 95% of the market's gains between 1963 and 1994 occurred during 1.2% of the trading days. An investor who was out of the market for the best 50 days of that 31-year period would have realized roughly the same annual returns as someone who put all his money in risk-free Treasury bills. Since the market tends to go up two out of every three days, market observers have a better chance of missing out on a big gain than avoiding a large loss.
About That Big Gain ...
The best way to beat the market is to buy great companies trading at fair prices, and to hold those companies over the long haul. While it can be unnerving to see one of your holdings shed a significant chunk of its value in the amount of time it takes Jim Cramer to throw a televised temper tantrum, it's important to maintain a long-term perspective. When your stocks are down, reassess your original investment thesis. If you still believe a company will be a long-term winner, consider adding to your position.
We can't predict what a stock will do during any given day, week, month, or year. As you can see from the chart to the left, over the past five years, our Stock Advisor recommendations have risen and fallen regularly, sometimes violently. While the zigs and zags are always exciting, we prefer to concentrate on our portfolio's long-term trend of moving upward, and to the right.
September 2007 Issue: Page 10 of 10
Fool's Tools: Don't Try to Time the Market
By Rich Greifner
Many Stock Advisor subscribers likely are familiar with the old Wall Street adage, "sell in May and go away," a strategy that attempts to exploit the historical trend of poor market performance during the summer months. There's just one tiny problem with that rule, as well as nearly every other market timing strategy: It doesn't work.
According to the Stock Trader's Almanac, a strategy of investing in Dow Jones stocks during the "good six months" of the year (November through April) and switching to fixed income securities during the "worst six months" (May through October) would have grown an initial $10,000 investment into $544,323 over a 56-year period. Meanwhile, the opposite strategy -- which I will dub, "sell in November and hope to remember" -- would have lost money over the same period. So why don't we endorse this approach?
Next Stop ... Bangladesh!
"Sell in May" is hardly the only market-timing strategy that can demonstrate above-average returns by manipulating historical data. There's the Super Bowl predictor, the Presidential Election cycle, and my personal favorite, the Hemline Indicator, which ties stock market performance to the length of women's skirts (naturally, shorter is better).
So You're Saying There's a Chance?
While the recent stock market volatility illustrates the enormous potential gains from market timing, most experts agree that jumping in and out of stocks is a recipe for disaster. In 1975, Nobel laureate William Sharpe concluded that "attempts to time the market are not likely to produce incremental returns of more than 4 percent per year over the long run." Sharpe concluded that unless a market-timer could accurately forecast market conditions 70% of the time, he was better off with a simple buy-and-hold strategy.
The adverse effects of market timing can even negate the returns of a master investor. Although the Fidelity Magellan Fund raked in astounding 29% annual returns during manager Peter Lynch's 13-year tenure, individual investors didn't fare as well. Lynch believes that most Magellan investors actually lost money over that period by jumping in when the fund was hot and pulling out when things cooled off. Individual investors tend to buy high and sell low -- not an optimal investing strategy.
Statistically speaking, investors' returns suffer when they stash assets on the sidelines. Consider that 95% of the market's gains between 1963 and 1994 occurred during 1.2% of the trading days. An investor who was out of the market for the best 50 days of that 31-year period would have realized roughly the same annual returns as someone who put all his money in risk-free Treasury bills. Since the market tends to go up two out of every three days, market observers have a better chance of missing out on a big gain than avoiding a large loss.
About That Big Gain ...
The best way to beat the market is to buy great companies trading at fair prices, and to hold those companies over the long haul. While it can be unnerving to see one of your holdings shed a significant chunk of its value in the amount of time it takes Jim Cramer to throw a televised temper tantrum, it's important to maintain a long-term perspective. When your stocks are down, reassess your original investment thesis. If you still believe a company will be a long-term winner, consider adding to your position.
We can't predict what a stock will do during any given day, week, month, or year. As you can see from the chart to the left, over the past five years, our Stock Advisor recommendations have risen and fallen regularly, sometimes violently. While the zigs and zags are always exciting, we prefer to concentrate on our portfolio's long-term trend of moving upward, and to the right.
