Market timing refers to the practice of jumping in and out of the stock market in an attempt to avoid market declines.
Suppose that a market timer decides at the beginning of each month whether to have all of his money in the S&P 500 stocks or all of it in cash. His goal is to avoid being in stocks during the months where stocks perform worse than cash.
Each month the market timer has a certain probability of guessing right. If he just tosses a coin, this probability is 50%. The question is how high this probability has to be for the market timer to beat the strategy of just buying and holding through thick and thin.
I gathered data on the S&P 500 from December 1990 to March 2008 and ran some simulations. For each fixed probability of the market timer guessing right each month, I ran 10 million Monte Carlo simulations and averaged out the results.
To account for commissions, costs due to stock spreads, and interest on cash, I assumed that the net return of interest minus costs averaged 3% per year while the market timer has his money out of stocks.
A buy and hold investor over this period of time would have received an average compound return of 11.0% per year. From the results chart, we see that the market timer has to be right 60% of the time just to break even with the investor who buys and holds.
If the market timer is right only 50% of the time, he will underperform the buy and hold strategy by 4.2% per year, on average. This is a huge penalty for just guessing.
Over the full period, an initial investment of $100,000 grew to $606,000 by buying and holding. A market timer who tosses a coin each month will have a median outcome of only $312,000! This shows that our market timer missed many months where stocks rose significantly.
It seems to be human nature to be tempted to believe that we can do better than buying and holding by anticipating market declines. The next time you are tempted to try market timing, remember that you have to be right 60% of the time (and the people you trade against have to be wrong 60% of the time) just for you to break even. Do you really believe that you are that much better than all the other market timers?