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The Tradeoff of Market Timing

Posted: Brandon Arns

Timing the market is the holy grail of investing. On one hand, traders try to time the market opportunistically to achieve higher returns. On the other, many portfolio managers try to sidestep bad market conditions to lower the risk of the portfolio. The effect of compounding can make this a worthwhile practice, as seen in the table below:

When you lose 50% on an investment, you need 100% gain to get back to even. Obviously, this can take a long time and could cripple one’s financial goals, so it makes sense to try and avoid the losses. However, there’s an opportunity cost. While it’s invaluable to protect from losses, doing so for too long can be equally destructive. The table below shows the opportunity cost of waiting for a steep loss. For example, if the market gains 50% while you wait for better opportunities, you need it to drop by a third to be “right.”

This is one reason why a diversified portfolio makes sense for most people. It’s easy to make an argument for why the market could continue its recent rally and load up on tech stocks. On the other hand, we’re 10+ years into a bull market for stocks and there are concerns about economic growth and market valuations. Perhaps it’s time to take the chips off the table. The tables above demonstrate the potential ramifications of doing too much of either and being wrong. Diversification to an extent is admitting you can’t predict the future and aren’t willing to gamble your financial life on trying.

The tables and thoughts behind this blog come from something I read recently from Ben Carlson of Ritholtz Wealth Management. He writes about this effect using some great visualizations in “Putting the Next Market Downturn into Perspective.”

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