November 7, 2011 / 7:52 PM / 8 years ago

How not to time the market

(Reuters) - When the Dow Jones Industrial Average falls, rises, and falls again by triple digits, and when August’s outflow of nearly $40 billion from equity mutual funds was the largest since October 2008, it’s tempting for even experienced investors to flee the stock market.

That could have been the right strategy if you were not appropriately invested, but horrible if you were trying to time the market. Why? You can’t be sure when stock prices reach their lows or highs for any market cycle - or how much it would matter to have remained out when prices hit either.

Consider, for example, an analysis by T Rowe Price, based on the S&P 500, a popular benchmark for measuring the performance of the stock market: If you could have been fully invested in the index from December 31, 1995 to December 31, 2010, your annual return would have averaged 6.76 percent based only on the 500 stocks’ prices - that is, excluding their reinvested dividends (which are included in total returns).

If you had missed being in stocks on the market’s 10 best days of those 15 years, your average annual return would have only been 1.93 percent. If you had missed the 20 best days, your average annual return would have been minus 1.19 percent.

On the other hand, consider the findings of a Vanguard research paper, which looked at S&P returns (averaging 5 percent annually and also excluding reinvested dividends) during a much longer period, 1928-2008. Missing either the 20 worst or the 20 best trading days in the 81-year period would have increased or decreased an investor’s overall return by approximately 50 percent, the report says.

For a real-life example of the risks and rewards inherent in being in or out of the market in a single year, consider the experience of Dr. Rajendra Prasad, a Long Beach, California-based doctor, who started the Prasad Growth Fund in 1998 and guided the fund in 2008, a recession year, to number one of 432 funds in the small-cap growth fund category at Lipper, a Thomson Reuters company.

He credits his market timing, as well as stock selection, strategies for achieving the total return of minus 7.4 percent that year, which was good enough to beat the S&P 500’s minus 37.0 percent and Russell 2000 (Small-Cap) Growth Index’s minus 38.5 percent by a country mile.

All of this, unfortunately, was a remote memory when the fund’s latest fiscal year ended last March 31, with a total return of minus 37.5 percent, dropping to the bottom of its Lipper peer group, while Russell’s index was up 31.0 percent and the S&P 500, 15.7 percent.

“I had been subscribing to a number of newsletters written by some prominent financial gurus,” Dr. Prasad reported to shareholders. “Many of them were forecasting a crash of the market...following the crash of 2008... Because of this, I was positioned for an imminent crash... It did not happen in 2010.”

In an email exchange, he recalls “repeatedly” taking losses not only in stocks but also in both put options and, perhaps more importantly, certain types of exchange-traded funds (ETFs), in which he had invested “based on the negativity the newsletters were indicating.”

If you were to temporarily unbalance a balanced long-term portfolio by leaving well-researched equity funds for these ETFs, which offer prospects for making money in a bear market, you could be accepting a much larger potential risk than by just finding refuge from stocks in a money market mutual fund.

Whether you’re an individual temporarily unbalancing a balanced long-term portfolio by dumping equity funds or an actively trading portfolio manager reducing a fund’s exposure to the stock market, moving to these ETFs, which offer prospects for making money in a bear market, is, naturally, more risky than the alternative of a money market mutual fund.

Unlike traditional ETFs, which resemble mutual funds, the newer “inverse ETFs” and “leveraged inverse ETFs” meet their investment objectives by going up when stock indexes which they track go down, as Dr. Prasad had expected in 2000 - or go down when, as happened to him in 2000, the market goes up.

An inverse ETF targeting the S&P 500 should go up 1 percent on a day when the index goes down 1 percent, and vice versa.

A leveraged inverse ETF is managed to achieve a multiple - say, double or triple - of the opposite of an index’s performance. Thus, a fund which would go up 2 percent on a day when the 500 falls 1 percent would fall 2 percent when the 500 rises 1 percent.

It is critically important to remember that these ETFs are managed to meet their investment objectives within one day and, therefore, must be closely watched. "The lesson? Leverage kills," says Dan Wiener, who edits The Independent Adviser for Vanguard Investors (see link.reuters.com/zam84s). "For the individual investor it strikes me that the growing interest in and availability of leveraged ETFs is where they can go wrong." So in making bets on or against bonds, stocks and commodities, take heed: "If you get on the wrong side of the bet, you can get in trouble."

You could suffer truly huge losses if you hold these ETFs longer than one day. That, after all, is what they are managed for.

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The author is a Reuters contributor. The opinions expressed are his own.

Additional reporting by Lou Carlozo. Editing by Lauren Young and Beth Gladstone.

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