- Research suggests timing the market is extremely difficult for the average investor to do and will likely cause you more harm than good.
- By pulling cash out of the market to try and avoid downturns you can miss out on big rallies, which really hurts your long-term returns.
- Based on extensive research, we share two winning strategies to handle a market downturn.
- We explain why recession forecasting is different than market timing, and how to avoid losses and earn profits during a recession.
“I just sold everything to avoid a stock market crash!”
Get Out Before a Stock Market Crash?
When we think stocks might crash, should we move our portfolio into something safe (such as cash, bonds, or money market funds) and try to avoid a possible correction?
Essentially, should we try and time the market by jumping out at the top and jumping back in at the bottom?
The short answer is this: Research suggests timing the market is extremely difficult for the average investor to do and will likely cause you more harm than good.
The One Big Caveat
Over the last 90 years, the stock market has created incredible wealth and the general trend has been a steady march upwards. If you simply held through every selloff, correction, depression, and bear market, you would’ve done incredibly well. Over time, the U.S. stock market has followed the U.S. economy and delivered a trend of upward growth.
However, when you zoom in on the short term that steady upward march has seen many volatile pockets where markets have declined significantly, even catastrophically, at times.
If you were fully invested during one of these downturns and simply held through it, you probably recovered and continued to gain over the next 5-10 years (more true after 1975 than before). But if you needed your invested cash for something outside of investing, you may have found yourself forced to sell out of your positions for a large loss.
Take for example the most recent crash of 2008 – 2009. The S&P 500 declined roughly 55% from its peak during the selloff, hitting a low point in March, 2009. If you were planning to buy a home or retire in 2009, you were devastated.
Over half your money was gone.
So the big caveat is this: You should only invest money in the market that you won’t need for the next 5-10 years and could keep invested through a downturn.
So if, for example, you’re planning to buy a home or retire in the near future, you should look carefully at how much you keep invested in the market compared to how much you expect to need in cash.
It’s Incredibly Difficult to Avoid a Stock Market Crash
Research suggests the answer is “No.”
There are two big reasons why it’s not a great strategy to try and avoid a possible stock market crash:
- It’s really hard for the average investor to do successfully
- Missing out on a possible rally by putting cash on the sidelines can really hurt your long-term returns
First of all, why is it so hard to time the market? It’s really tempting to look back at crashes and think, “Well if I had just sold right there, then I would’ve avoided the whole downturn.”
In 2016, quantitative research investment firm AQR published an interesting paper on using market timing to avoid crashes. Looking back at 115 years of market data, they found that selling out of the market based on indicators of market overvaluation had failed to beat a passive buy-and-hold strategy, especially over the last 60 years.
AQR concluded that timing the market based on a mix of value and momentum indicators might work better, and that savvy quantitative investors could try to use a quantitative blend to “sin a little” when it comes to market timing.
So one of the top quant-based investment firms basically concluded that maybe if you’re good at quantitative analysis you could try to time the market a little. But overall, timing the market based on valuation metrics is not a good strategy.
Looking at it from another angle, the CXO Advisory Group ran a study to determine how good financial “gurus” were at predicting the direction of the market. From 2005 through 2012 they collected 6,582 forecasts offered publicly by 68 experts, bulls and bears employing technical, fundamental, and sentiment indicators.
Overall, they found the accuracy of these gurus to be roughly 47% – meaning these expert forecasters were wrong when predicting market direction more often than they were right.
Even the seven best gurus were right only 60% – 68% of the time. Statistically speaking, being right that often is actually very impressive (and very lucrative). But it’s a short sample period and some gurus are likely to be right more often than others just by chance. It’s not clear their predictive abilities would stand the test of time and several different market declines.
There are other examples, but these two underscore our first point: It’s not clear that anyone (even the experts) can successfully know when, exactly, is the right time to sell.
Missing Out on Stock Market Rallies Can Devastate Your Profits
This brings us to our second point: By pulling cash out of the market to try and avoid downturns you can miss out on big rallies, which really hurts your long-term returns.
Or, to quote legendary investor Peter Lynch, “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
Most of the stock market’s gains tend to be delivered in small pockets of concentrated strong performance. If you happen to be sitting on the sidelines waiting for a pullback during some of these pockets of performance, you can lose out big time.
The Cogent Advisor shared a relevant analysis. They looked at data for 91 calendar years (or 1,092 months) of U.S. investment returns over the period 1927 through 2016 and found:
“While the average month returned 0.95%, if we eliminate the best-performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1%). In other words, 8.5% of the months provided almost 100% of the returns.
The best-performing 91 months, an average of just one month a year, earned an average return of 10.5%.
While the average quarter returned of 3.0%, if we eliminate the best-performing 91 quarters, the remaining 273 quarters (three-fourths of the time period) actually lost money, providing an average return of -0.8%. In other words, just 25% of the period provided more than 100% of the returns.
The best-performing 91 quarters, an average of just one quarter a year, earned an average return of 14.3%.”
Similarly, Calamos Investments analyzed the 20-year period from 1996 – 2016 and found that missing just the 10 best days of performance during that period would cut your total returns in HALF.
Indeed, it’s telling that there seems to be much discussion on the topic of stock market timing during 2016 and 2017, when investors often felt the bull market couldn’t possibly go much higher.
But who could have anticipated that the S&P 500 would rally another 42% (including dividends) from November 9, 2016 (the morning after President Trump won the U.S. presidential election) through September 21, 2018 (the date we wrote this article)?
If you had moved to cash out of fear of an upcoming stock market crash (as some investors did in 2016) you would’ve missed another 42% upside.
Watch for Upcoming Recessions
While we don’t believe in market timing, we do have one important distinction to our “don’t try to time the market” rule:
Watch out for recessions on the horizon.
How is that different than market timing?
When most investors are market timing, they’re trying to perfectly time small gains and declines in the market, usually based on nothing more than emotion and market movement. This approach is destined to fail.
What we practice is recession forecasting, which involves using robust economic data and forecast modeling to spot upcoming recessions and adjust our investment strategy accordingly.
We explain the difference between market timing and recession forecasting, as well as how to play defense (avoid losses) and offense (earn profits) during a recession in great detail in these two lessons:
- Lesson 10: Stock Market Crashes: Why Markets Decline & How to Survive
- Lesson 29: How to Profit During Economic Recessions
What Should You Do During a Stock Market Crash?
Buying the Best Stocks is Your Best Defense Against a Stock Market Crash
Knowing when to enter and exit the market is hard. Really hard.
So in our opinion, the best strategy is to make sure you’re only investing money you won’t need in the next 5-10 years, and then leave it fully invested, rebalancing frequently into the best stocks for your goals.