Timing Isn't Everything: The Pitfalls of Market Timing

Timing Isn't Everything: The Pitfalls of Market Timing

May 25, 2023

Article: Peter Lynch, the renowned investor who managed the successful Fidelity Magellan Fund from 1977 to 1990, achieved extraordinary annual returns averaging 29%*. It might seem like following Lynch's lead would guarantee phenomenal profits, but the reality was quite different. Surprisingly, during Lynch's tenure, the average Magellan Fund investor actually lost money, as reported by Fidelity Investments (1). This raises the question: how does this happen?

While this extreme example may highlight the challenges faced by individual investors, it also underscores the behavioral issues plaguing them. According to Dalbar's 2022 investor behavior study (2), the average equity fund investor underperformed the stock market, represented by the S&P 500, by 2.84% over the 30-year period ending in 2022. The S&P 500 delivered an annualized return of 9.65% during that period, while the average equity fund investor earned only 6.81%. So, what causes this gap, and how can investors overcome it?

One of the main reasons for investor underperformance is poor decision-making. As the great investor Benjamin Graham once stated, "The investor's chief problem — and even his worst enemy — is likely to be himself." Investors without a well-conceived investment plan or the conviction to stick with it often allow their emotions to drive their decisions.

Instead of focusing on their investment objectives, they tend to follow the herd, panicking and selling during market downturns or buying at market peaks. Some attempt to chase performance by investing in "market winners" — stocks or mutual funds that are currently leading the market. Others believe they can time the market, predicting its direction to buy low and sell high. All of these behaviors come with significant risks and often lead to poor outcomes.

This could possibly explain the severe underperformance experienced by investors in the Magellan Fund. While Lynch achieved an average annual return of 29% from 1977 to 1990, he had exceptional years of outperformance as well as periods of underperformance. For example, in 1980, the fund recorded a remarkable 70% return, but the following year, Lynch underperformed the sector. Investors who joined the fund when it was soaring in 1980 might have been disappointed by its performance in 1981 and decided to jump ship in search of another "market winner." However, by doing so, they would have locked in their losses.(2)

Understanding the Cost of Timing the Market

To comprehend the significant cost of attempting to time the market, let's consider the odds. According to Morningstar, to beat the S&P Index, one would need to correctly predict the market's direction two out of three times. Additionally, one would need to make two accurate decisions each time: when to exit and when to re-enter the market. Achieving such precision is near impossible.

Morningstar has calculated the actual cost of market timing based on their data. Investors who remained invested in the stock market for all 5,217 trading days between 1997 and 2017 generated a compound annual return of 7.2%. However, if they missed the 10 best trading days during that period, their return would have plummeted to 3.5%. Missing the 50 best days would have resulted in a loss of 4.5%. The challenge for market timers is that the most significant market gains tend to occur during or after market corrections.

The information contained herein is obtained from carefully selected sources believed to be reliable, but the accuracy or completeness is not guaranteed. This report is for information purposes only and is not a solicitation that any particular investor should purchase or sell any particular security, including the Fidelity Magellan Fund. Past performance is no guarantee of future returns. Real returns can and will vary. Investing involves risk and you may incur a profit or a loss. Please carefully consider investment objectives, risks, charges, and expenses before investing.

(2) Forbes June 2, 2021 “How Investors Are Costing Themselves Money”.

(3) DALBAR December 31, 2022 QAIB Report.