Investors often go through period of hightened risk aversion and focus too much on avoid losses while ignoring the opportunties. Ther are many reason that can motivate investor to stay out of the market, including:
- generally pessimistic view of the economy due to underlying structural issues leading to increased expectation of a recession
- confirmaiton bias that lead to interpretation of the econmic data in a way that support pre-existing psymistic beliefs
- uncertainity causing investor to think that political, global or other exogenous events have disproportionately large or long-lasting impact on performance of the financial assets
- anxiety that new policies will have a far-reaching effects beyond their immediate scope, influencing broader economic outcomes and negatively impacting financial market
- believe that new technology will significantly changing consumer behavior and negatively impact affected industries
Whichever reason overly risk averse investor have, the belive is that ‘market correction is coming’ and by pulling out of the market he or she can avoid losses. One of the greatest investors when asked if he positioning portoflio for expected recession said:
“Far more money has been lost by investors in preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.” – Peter Lynch
By ‘lost money’ Peter Lynch means potential gains that an investor misses out on when they choose to hold cash instead of being invested. Those potential gains are the opportunity costs bear by those who are overly cautious. Based on a wider context of multiple interviews and his book(“One Up on Wall Street“), Lynch meant that a longer period the opportunity cost of trying to get out of the market in anticipation of the upcoming recession is on average much higher than a long-term, steady approach of staying fully invested and bracing for the short-term market fluctuations and periods of increased volatility.
A much more simplified version of Lynch’s ‘moving out and missing out’ principle, has been presented in ‘remove best performance days’ research covered by multiple asset managers (including Lynch’s employer Fidelity Investments). Depending on the sample and underlying index, investors can lose roughly 30-40% of total capital compounded over 40 years if they miss just 5 best-performing days during that period. The message is clear – timing the market leads to underperformance, and staying invested through ups and downs improves results. Although I generally agree with this conclusion, I don’t like that almost all materials covering this research show only one side of the coin (impact of removing Top 5, 10, 30… best performing days). The objective of investors who decide to stay ‘out of the market’, is to avoid negative days. Therefore I’ve recalculated the impact and presented a fairer comparison of 3 scenarios, which shows compounding results after removing (1) several best-performing days, but also (2) worst-performing days and (3) the equal number of best and worst-performing days.
As we can see the impact of removing both, the best-performing days and the worst-performing days is dramatic and removing both the top best and worst-performing days roughly negates each other (it becomes positive with an increased number of removed extreme observation.