Why Chasing Returns Can Hurt Your Portfolio
During periods of high market volatility, like the one we’re currently experiencing, it can be tempting to want to take your money out of the market right before you think it will drop, with the intention of reinvesting it once the market starts to recover. A perfect plan, if only we could consistently and accurately predict the future of the market over the short term. But the market moves on unexpected news, and there isn’t anyone who can know for certain at what moment the market has reached its highest or lowest point in any given period until after that moment has already passed.
Accordingly, history has shown it would be wiser to resist the urge to try and time the market. Volatile markets tend to have large swings to both the upside and the downside, which means the best days in the market are often concentrated around the worst days in the market. Taking your money out of the market to avoid a potential drop means you also risk not benefitting from a potential recovery.
The chart below illustrates how missing just a few days in the market can greatly impact a portfolio’s performance over the years.
Morningstar recently published its annual “Mind the Gap” report, which further illustrates the dangers of market timing. The report estimates that the “average dollar invested in U.S. mutual funds and exchange-traded funds earned 6.3% per year over the 10 years ended December 31, 2023. That is approximately 1.1% per year less than the average fund’s total return over the same period assuming an initial lump-sum purchase. The 1.1% gap is explained by the timing of investors’ purchases and sales of fund shares.”1
This gap is illustrated in the following chart.
This data shows that market timing behaviors cause investors to miss out on 1.1% in returns each year, or about 15% of funds’ aggregate average total return.
Consider what that means for a long-term investor. For example, an investor who engaged in market timing behavior over the 15-year period ending December 31, 2023, would have experienced a 15% decrease in investment growth. This loss illustrates that investors’ biggest threat may not be from market volatility but rather from the risk of missing out on days invested in the market.
When speaking about market volatility, Creative Planning President and CEO Peter Mallouk often asks audience members, “What’s the one thing that all bear markets have in common?” The correct answer is, “They all eventually end.” Historically, markets have shown the tendency to recover from downturns. The key to success is making sure you have a plan in place and that your portfolio is appropriately diversified and customized to match your individual time-horizon and risk tolerance. With those factors in place, you may potentially benefit from the eventual rebound during times of market volatility. If you take your money out of the market, not only are you missing out on opportunities to buy stocks at a “discount” to their normal prices but you’re also missing out on growth opportunities as the market eventually begins to rebound.
So, what’s the best way to invest during periods of market volatility? That depends on your particular financial situation, investment time horizon, future goals, risk tolerance, retirement income needs, estate planning goals and more. For example, an investor who hopes to retire in five years will approach market volatility differently than a 25-year-old who is just beginning to invest. A solid strategy is to work with a qualified wealth manager to develop a diversified portfolio allocation that’s in line with your needs and positioned to weather long-term market volatility.
Once you’ve established your portfolio, regularly review progress with your wealth manager, but avoid the urge to sell out when things get rocky. Instead, remind yourself that the key to overcoming the investment return gap is to remain true to your long-term goals and be prepared to experience volatility along the way. It’s all a normal part of the market cycle.
