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This article is featured in the winter edition of our 360 Insights Quarterly Client Newsletter. 

Many months of stock market highs have led investors to ask, “How long is this going to last, and when should I get out?”

Intuition tells us that after such a long period of sustained performance we might be due for a correction. This instinctive thinking also occurs in baseball, when a batter is “due” for a hit after a prolonged string of hitless at-bats, and in gambling, with the belief that you might be “due” to see the ball land on black after a string of red spins at the roulette wheel.

This Fallacy of the Maturity of Chances (also referred to as the Monte Carlo Fallacy) can result in faulty decision-making which when left unchecked adversely impacts the likelihood of investors achieving their long-term goals.

Despite what some may claim, no one can predict how long stock markets will remain high (by the time this newsletter is published, markets may have dropped…or risen further). We have no control over stock market performance.

But we believe asking “When should I get out?” is the wrong question.

Here’s why: Investors who attempt to time the market run the risk of missing periods of exceptional returns, leading to significant adverse effects on the value of their portfolios.

The chart below illustrates the risk of attempting to time the stock market over the past 20 years by showing the returns investors would have achieved if they had missed some of the best days in the market.

The Cost of Market Timing
Risk of Missing the Best Days in the Market 1997-2016

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. ©Morningstar. All Rights Reserved.

Investors who stayed in large cap stocks for all 5,218 trading days between the beginning of 1997 and the end of 2016, achieved a compound annual return of 7.7%. However, they would have received only 4.0% if they missed the 10 best days of stock returns. Missing the 50 best days would have produced an annual loss of 4.2%.

The appeal of market timing is obvious: improving portfolio returns by managing to avoid periods of poor performance. Let’s imagine for a moment that you were able to find out when the market was at its peak and could get out the day before the market dropped. That sounds great, but there is still another important question: How would you know when to get back in? Timing the market consistently is extremely difficult. And unsuccessful market timing — the more likely result — can lead to compromising your most important life goals.

Looking back over the past nearly 50 years of stock market performance, there were many up and down markets, but their length and magnitude appear to be random. We don’t know if the current bull market will last another decade or just another month. But whenever downturns have occurred these bear markets have lasted on average less than two years since 1970.

Bull/Bear Market Chart
S&P 500 Total Return, July 1970-September 2017

Source: Morningstar Direct 2017. Monthly returns. Bull and Bear markets categorized by +/- 20% cumulative gains on monthly returns. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. All investments involve risk, including loss of principal.

So instead of worrying and wondering how long the current stock market performance will last, focus on maintaining a long-term outlook for your investment strategies and work with your advisor to develop a plan that is aligned with your life goals.

 

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