Why does trying to “time the market” so often fail?

Ben Raven - Director

Had you invested in the FTSE All Share Index at the start of 1997, and held your investment for 20 years, you would have celebrated New Years Eve 2016 with a profit of +268%. An average annual return of approximately 5%, compounded over a quarter of a century. Few, if any, would be disappointed with that return whatever their risk appetite.

Over that same period, thousands of active fund managers have attempted to out-perform indices. These active fund managers charge a premium (usually their Annual Management Charge) and attempt to generate ‘alpha’ for their investors. Alpha is the return achieved in excess of the benchmark. The IA Flexible Investment Sector reflects the performance of active managers seeking to outperform the equity markets. Whilst not all of these invest solely in the UK, there are high correlations across global equity markets and the return of the IA Flexible Sector over the 20-year period was +239%.
So why is it so difficult for active managers to outperform an index?

I have previously explained the punitive, and hidden, charges involved in running an active mandate (see previous blog “Active Funds; why does nobody mention trading charges?”). Charges make life extremely challenging for an active manager, but there are still those whose funds can absorb them and achieve alpha. The questions are just how good do they have to be, and does that represent a sound investment?

The 20 years in question comprised 5,216 trading days.
The active managers identified their highest conviction trades, incurred the trading charge for implementing them, and waited for the binary outcome; would the value of their position go up or down? Sometimes the move was logical, other times it seemed to defy logic. The better managers won on trades more than they lost. However, the problem is that not all trading days are equally important and if you aren’t invested on the most important days, the impact can be devastating. So how significant are the most important days out of 5,216?
The FTSE All Share Index made +268% over 5,216 days. If you had tracked the index, and missed just the 5 best days (0.10% of the days) your return would have reduced by almost half to +153%. If you missed the 10 best days (0.19%) you would have gained +99%; missing the 20 best days (0.38%) reduced the return to +31% and missing the best 25 days (0.48%) would have seen you barely break even at +9%.
Perhaps most astonishingly, if you were unlucky enough to miss the best 30 trading days (0.58%) you would have lost money with a return of -8%.
That is to say you could have been invested for 5,186 of the 5,216 days, or 99.42% of the time, and you would have lost money. Meanwhile the person that remained fully invested throughout, would have made +268%.
Whilst there are undoubtedly some extremely capable investment managers in our industry, nobody has the ability to predict the future:

Timing the market consistently over a long time-frame is practically impossible and attempting to do so can detrimentally impact the returns on offer.

In order to maximise one’s long-term investment return there is a compelling argument for populating a portfolio with long-only index-tracking, or Exchange Traded Funds (ETFs).

Assuming the portfolio is well diversified, managed daily and structured in the most cost and tax efficient manner, investors can remain invested 100% of the time and reap the benefits on offer.

Pay a fund manager to “time the market” (in the hope of achieving alpha) and money can be lost simply by being “out of the market” on only a small number of days that are usually impossible to predict.
Using our example, had you missed out on just 30 days in 20 years you would have lost money.

Conversely if you had just sat tight your initial stake would have almost quadrupled! Markets can bounce back very quickly after a sell off and remaining fully invested can lead to significantly better performance over the long run.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data:  Tavistock Wealth Limited and MoneyWeek.

Tavistock Wealth Limited is authorised and regulated by the Financial Conduct Authority and is a wholly owned subsidiary of Tavistock Investments Plc.

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