CapitalSpring - The Power of Compound Returns: Why Time in the market Beats Timing the Market

The Power of Compound Returns: Why Time in the market Beats Timing the Market

Global markets experienced heightened levels of volatility in the past 12 months, with investors grappling with inflation, central bank policy, ongoing geopolitical tensions, and economic uncertainty.

Many investors were tempted to time the market, hoping to buy low and sell high to maximize their returns. However, as we will explore in this report, attempting to time the market is an extremely challenging strategy to implement correctly and consistently. This is especially true with extreme market timing tactics, such as moving a majority of one's investment assets to cash to avoid a bear market or benefit from a major market correction. Instead, remaining relatively “invested” over the long term has proven to be a much more reliable strategy for achieving sustainable investment returns.

The Danger of Going to Cash

Trying to aggressively time the peaks and troughs of market cycles can prove risky, since it is extremely difficult to predict when those major troughs and peaks will occur. Equity markets can get volatile in the short term, but over the long term they tend to rise. This means that an investor who stays in the market generally has a much higher probability of long-term success than one who tries to pick the perfect time to invest.

Historically, each market downturn has been followed by an eventual upswing. As a long-term investor, it is important not to worry about trying to get the absolute lowest point when putting cash into the market. Dollar cost averaging is generally a better strategy. The concerns that keep investors on the sidelines may save them that pain, but it may ensure they will miss the gain.

Figure 1: The power of long term compounding versus cash over 30 years

After a 15% fall from the peak in April 2022 to the trough of June 2022, the ASX200 recovered by 10% into year-end and has continued to move higher so far through 2023, rebounding 14% to date from the June 2022 low. This recent example illustrates that one of the biggest risks in attempting to time markets is potentially missing out on market rallies which tend to follow market downturns.

Figure 2: Since the highest gains often occur during or soon after a correction, missing these gains may drastically reduce an investor’s average returns over time

The Risk of Missing out

The past decade has been unsettling for many investors. The recession of 2008–2009 made some investors so fearful that they stopped contributing to their accounts, or even withdrew their money at market lows, thus locking in the losses. The very sharp but short Covid market dislocation was another good example. Investors may have thought sitting out for a while seemed like a good strategy however the Covid rebound was very rapid. Trying to avoid the worst drops means also missing the opportunity for gains (and frequently investors get out too late to avoid the worst of the decline).

“Time in” the market generally beats “timing” the market because many of the best days occur during or immediately following downturns. Looking at the past 30 years, the 10 best trading days occurred during recessions and five of them took place during a bear market. For a recent example, three of the best days for stocks in the past 30 years occurred in March and April 2020.

Being invested (and remaining relatively invested) in the market is the key to long-term investment success. While it can be tempting to try and avoid the worst days in the market, it is nearly impossible to both avoid the worst days and capture the best days. Figures 3 and 4 show the impact that missing the best trading days of the Australian equities market can have on investment returns.

Figure 3: Missing just a few days of positive market gains can significantly reduce the value of your overall return

Figure 4: Large daily moves are a feature of high volatility periods, as has been the case over the last 5 years, making the difference in returns even more pronounced

If an investor was invested in the market for a full 10-year period to date, the annualised return the investor would have generated is 8.6%. This is an outstanding annualised return, especially considering the period includes the near-bear market of 2018, the Covid recession of 2020, and the 40-year high inflation and bear market of 2022.

By missing just the 10 best trading days during those 10 years, an investor’s annualised return was halved – a significant impact when you consider it equates to missing an average of just one day in the market every 12 months.

In the worst-case scenario, if an investor mistimed the market and missed out on the best 50 trading days, over the same period the annualised return would have been -5.2%. This illustrates that by being out of the market, the opportunity cost can be great. Since the highest gains often occur during or soon after a correction, missing these gains may drastically reduce an investor’s average returns over time.

Of course, investors could also leave the market and miss the worst days. However, studies show that people generally stop investing when the market is down, after an especially difficult downturn, and they return after the market has already begun to bounce back.

Keeping a Long-term Focus

Keeping a long-term investment perspective is important – particularly for growth-oriented investment strategies. It is easy to get caught up in short-term volatility, particularly when markets either fall or go through bouts of volatility.

Investing in growth assets requires that investors adopt a long-term investment time horizon and accept that the value of their portfolio will fluctuate considerably over short periods of time.

Figure 5: Maintaining a long-term perspective is crucial as it allows investors to benefit from the smoothing effect of longer-term rolling returns

History has shown that positive outcomes occur much more often over longer periods than shorter ones. As you can see in Figure 6, one-year investments produced negative results more often than investments held for longer periods. If those short-term, one-year investors had held on for just two or more years, they would have experienced nearly half as many negative periods.

And the longer the time frame, through highs and lows, the greater the chances of a positive outcome. Indeed, over the past 60 years, 90% of 10-year periods have been positive ones. Investors who have stayed in the market through occasional (and inevitable) periods of declining stock prices historically have been rewarded for their long-term outlook.

Figure 6: History has shown that the longer the investment period is, the greater the chances of a positive outcome

Time is Your Ally

Rather than trying to aggressively time highs and lows, it is important to stay invested through full market cycles. Focus on the time you stay invested, rather than on the timing of your investments.

Being invested (and remaining invested) in the market is the key to long-term investment success. The temptation to “time” the market and deviate significantly from your strategic asset allocation during volatile markets is strong, yet the opportunity cost can be great. It is extremely difficult to predict the start of the next downturn or what markets are going to do over the short term.

A growth-oriented investor’s true advantage lies in the understanding of long-term capital market returns and the power of compounding returns versus hiding one’s cash under the mattress or in a bank account.

It is also worth mentioning that volatile times are when active management and thoughtful (diversified) portfolio construction can earn their keep by adjusting exposures to better weather the bumps. We recommend employing a balanced and incremental approach to implementation. A smoothed progressive entry into markets is likely to yield even more positive results.