Investing 101: The cost of cashing out

Staying resolute to a plan

A key principle of investing is staying resolute to a robust investment strategy, rather than reacting to short-term swings in the prices of financial assets.

High inflation and rising interest rates created a challenging market environment from the start of 2022, leading to sharply lower prices in some asset classes. These events are not common, so when they happen, they can encourage some investors to deviate from their long-term strategy. However, doing so can be detrimental to building long-term wealth.

Timing the market doesn't work

When markets are volatile, it can be tempting to try to ‘time the market’ with the hope of lower asset prices later on. However, this approach can be costly in terms of performance.

The chart below shows the behaviour of S&P 500 Exchange Traded Fund (‘ETF’) investors during the Covid-19 selloff in 2020. The strongest selling (outflows) in ETFs only occurred around the time the S&P 500 was finding its lows.

The strongest buying (inflows) following this occurred only after significant gains had already occurred, suggesting that many of those who left the market re-entered but ‘too late’ and missed out on positive returns that they would have enjoyed had they stayed invested.

This pattern of getting both out of the market too late and getting back in too late is common during down markets, but is a recipe for long-term underperformance¹.

S&P 500 RETURNS AND ETF FLOWS AT THE START OF COVID-19

Source: CPB Global Investment Lab, Bloomberg. Data from 1 April 2019 to 30 April 2021. The purple solid and dotted line above shows the returns from cashing out of the S&P 500 Net Total Return Index at the date of the greatest ETF outflows (April 2020) and reinvesting at the date of the greatest ETF inflows during the subsequent rally (November 2020).

Trying to 'time' the S&P 500 index

We show this by examining the hypothetical performance of a ‘Consistent Investor’ and a ‘Market Timer’ who each invest a hypothetical$100,000 into the S&P 500 index on 31st December 1999, near the peak of the dotcom bubble. The Consistent Investor then simply stays invested.

The Market Timer sells entirely into cash (3-month Treasury bills) whenever the S&P 500 index falls by 10% or more in a quarter and then re-enters only after two consecutive quarters of positive returns.

We see that the forgone returns from trying to time markets add up over time. The Consistent Investor has outperformed the Market Timer by 175%² since 1999.

Sitting on the side-lines and waiting for clear recovery could mean missing opportunities and long-term underperformance compared to being invested.

HYPOTHETICAL PERFORMANCE AFTER INFLATION OF STAYING INVESTED VS. ‘TIMING THE MARKET’ SINCE 1999

Source: CPB Global Investment Lab using Bloomberg. Quarterly data 31 Dec 1999 to 30 September 2024. The Consistent Investor is invested into Equities throughout. Market Timing Investor begins invested into Equities but switches into Cash if Equities fall by 10% or more in a quarter and invests back into Equities only after 2 successive quarters of positive performance by Equities. Equities is the S&P 500 net total return index. Cash is the Barclays US 3-Month Libor Cash Index.

Turning points are hard to identify

Timing the market can be costly because identifying market turning points is difficult. The best days for asset returns often occur very close to the worst days during periods when prices are generally trending downwards, as the below chart illustrates for the S&P 500 index.

Since 1970, more than 90%³ of daily S&P 500 index gains of 4% or more occurred when the index was more than 10% below its most recent high. The chart below shows that there are often multiple rallies of this strength during down markets, which can make catching genuine turning points challenging.

Additionally, missing out on being invested during these days can be costly.

HISTORICAL RETURNS OF THE S&P 500 INDEX

Source: CPB Global Investment Lab using Bloomberg daily data from 2 January 1970 to 8 October 2024.

¹The purple solid and dotted line above shows the returns from cashing out of the S&P 500 Net Total Return Index at the date of the greatest ETF outflows (April 2020) and reinvesting at the date of the greatest ETF inflows during the subsequent rally (November 2020).

²Calculated between 31 Dec 1999 and 30 September 2024.

³Calculated between 2 January 1970 and 8 October 2024.