Risky Business
by Charles B. Carlson, CFA
Dow Theory Forecasts

I've always maintained that the biggest risk of investing is not so much being in the market when it goes down, but being out of the market when it goes up. Now I know that may seem hard to believe given the market's pounding in the last three years. But the fact is that if you are a long-term investor, the last thing you want to do is try to time market movements aggressively. Why? Because the penalties for being wrong are extremely harsh.

Standard & Poor's did a study looking at returns of the S&P 500 index for the 10-year period ended June 30, 2002. Here is what S&P found:

• Had an investor been fully invested in the S&P 500 index throughout the entire 10-year period, the average annual return would have been 11.43%.
• Had an investor been fully invested during the 10-year period except for just the five top trading days during that entire period, the average annual return would have dropped to 8.8%. In other words, by missing just the five best days in the market during that decade, your average annual return would have been reduced by more than two percentage points.
• Had an investor been fully invested except for the 20 best trading days during that entire 10-year period, the average annual return dropped to 3.3%.
• Had an investor been fully invested during the 10-year period except for the 30 best trading days, the average annual return would have been just 0.5%. In other words, by missing one months worth of top trading days but being invested the remaining 119 months would have left your portfolio with only a scant gain for the entire time period.
• Finally, had an investor been invested for all except the top 35 trading days during that 10-year period, the average annual return would have been a negative 0.8%.

What these results show is that the stock market moves in big but fairly brief bursts. Those big bursts account for the bulk of a market's gain over time. Thus, an investor who is not in the market to take advantage of those big bursts runs the risk of losing out big time over the long term.

Now I know someone is reading this who is saying - "Yes, the risks are high if you time the market - but so are the rewards!" True, an investor who would have timed the market correctly over the last three years would have dodged a lot of pain.

However, countless academic work over the years has shown that trying to aggressively time the market - that is, move 100% of your investment funds in and out of stocks depending on market conditions - is virtually impossible to do successfully over time. Notice I said over time. Sure, you are going to get lucky a time or two. But to call market tops and bottoms successfully over the long term truly is a fool's game. You will not be able to do it.

The moral of the story is this. As painful as bear markets can be, oftentimes the best strategy is to make sure your portfolio is properly diversified and ride out the pain. In that way, you assure yourself of being in the market when the inevitable upturn occurs.

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results.

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