Tuesday, May 29, 2007

Bad Timing, or Bad Reasoning?

My employer sends a small newsletter with each quarterly 401(k) statement. I skim over them, since they usually contain fairly basic information. This quarter, one of the articles was a little too basic...

The article discouraged participants from "timing" the market. I generally agree with that principle, but not for the reasons given. The article concluded that timing the market is risky because (1) if you missed the market's top-performing days, your portfolio's overall return would drop dramatically (see Chart 1), and (2) many mutual funds have rules against "market timing" (I think they really meant "rules against frequent trading").

My first thought after reading the first point was: what would have the performance been if I had missed the market's worst-performing days? When I look at Chart 2, I can't help but wish I would have missed those 10 worst days and doubled my annual average return over the period.

Granted, it's extremely improbable to be able to miss the 10 worst performing days; but I would think it equally improbable to happen to miss the 10 best performing days.

(Note: the charts above use S&P 500 returns net of dividends. Including dividends would not change the analysis in a meaningful way, since the dividends lost over 5 or 10 days would be negligible.)

As I mentioned, I would generally agree trying to time the market isn't a good idea; but it's not because you might miss those best days. Timing the market is extremely difficult and most would be better off with a well diversified portfolio.

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