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A silly story that investors should ignore

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Have you heard the one about how bad it is to miss the top-performing market days?

It goes like this: If you miss just a handful of the market's best days, your portfolio returns will be significantly reduced. For proof, the story comes with a chart that compares being invested in US stocks every single day versus missing a few of those top days.

One version of that chart shows that $100 invested in the S&P 500 since inception (from January 3, 1950 through February 20, 2015) would have grown to $12,667. Missing the top 5 days, however, brings the end value to just $8,203, or 35% less. Missing the top 25 days gets a miserable $2,966, or 77% less than just leaving the portfolio alone. The conclusion seems inevitable: it is a bad idea to cash out of the market for any period of time, lest you miss those crucial days.

As it turns out, this argument is seriously flawed. But because it has been parroted over and over, it has gained undeserved credibility. What’s wrong with it?

To begin with, it simply states an obvious fact: if you take out the best return days out of any investment, its total return will be lower. What is missing is the explanation for why an investor could possibly be out of the market ONLY during the days when returns were highest, but invested at all other times.

The chance of anyone accomplishing this exceedingly unlucky feat is minuscule. One could just as well say that avoiding a handful of really bad days creates enormous benefits. From a purely random perspective, both scenarios are very unlikely, but equally so because the number of positive days is about the same as the number of negative days.

While missing the best five days reduces this portfolio’s end value by 35%, avoiding the worst 5 days increases it by 82%. Avoiding the worst 25 days make results soar more than six-fold: you end up with $80,001 instead of $12,667.

Of course, nobody should believe that it is possible to avoid only the worst possible days. And it is just as unreasonable to assume that it is any more likely to miss just the best possible days.

A more realistic scenario would be this: what would happen if an investor misses BOTH extremes? It is a simple matter to tally the end value of the S&P 500 without its 8 best and 7 worst days, which is roughly the ratio of positive to negative days. The nice little surprise is that investors would be better off missing both the highest and lowest return days than being invested at all times. This is true for multiples of that 8-to-7 ratio as well.

An S&P 500 portfolio without extreme days has a superior performance.

Two lessons can be drawn from this. First, the myth that being out of the market for a minuscule period of time carries a serious risk is flawed. Institutional asset managers with an incentive to keep everyone invested at all times have been quite vocal at propagating this story, which is understandable: that’s how they are paid.

Second, there may be an advantage to be in and out of the market than to be invested at all times. But this is also an idea that needs to be examined closely.

On one hand, it is often the case that investors who try to time the market end up doing worse than if they remain always invested. This is because most people suffer from behavioral biases that lead them to making the wrong decisions.

Many times, for example, investors carry losing positions far longer than they should because they want to avoid the pain of booking a loss. This results in larger losses than if they had set an exit threshold in advance, such as a loss of 10% or 15%. We all know someone who lost 50% or more of his or her portfolio during the financial crisis before cashing out just as the market touched bottom and started going up again. The tendency to let losses run is responsible for many portfolio disasters.

On the other hand, there is a strong argument for adopting a systematic approach to asset allocation designed to deal with those investor shortcomings. This is the approach that is at the core of our investment strategy.

Using clear rules of exposure can go a long way towards avoiding the mistakes made when emotions drive investment decisions. Fear of loss, impulsive buying or selling, or drawing conclusions from a single event are well-known decision-making problems. Still, investors regularly fall into those traps.

To be fair, creating a dynamic strategy is not easy. This may well be the reason why simple stories like the “be invested at all times” above are so appealing. Following rules of thumb is much easier. But gross simplifications that ignore the complexities of market behavior can be useless and sometimes quite dangerous. Investors should ask their advisors to help them cut through the fog of fairy tales.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more