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One of the most common arguments used by advocates of buy and hold investing is the impact of missing the best days in the market. Its supporters claim that:
If you had missed the best 1% of all days for the S&P 500 Index between September 1928 and December 2010, your annualized returns excluding dividends would have decreased from 4.86% to -7.08 – a negative impact of 11.94%. On the other hand, missing the worst 1% would have boosted your returns from 4.86% to 19.09% – a positive impact of 14.23%.
S&P 500 Index: Missing Best & Worst Days, Price Only (September 1928 - December 2010)
Clearly, the damage caused by the worst days is greater than the upside generated by the best days. However, if extreme ups and downs occur in a random fashion and cannot be forecasted, then you are forced to choose between:
You Can’t Predict the Markets, BUT......
Attempts to predict market tops and bottoms have historically proven futile. Since 2000, the annual forecasts of chief market strategists for the S&P 500 Index have been less accurate than someone forecasting a 9% return at the beginning of each year (the long-term average return).
Just because you can’t spot turning points in markets, this doesn’t mean that you need to endure crushing losses during bear markets to get substantial upside participation in rising markets.
The majority of large up and down days occur after markets have already started declining. In other words, extreme days do not occur at random, but rather tend to happen during objectively identifiable market environments.
A simple test of whether the S&P 500 Index is above or below its average level over the past 200 days has been a powerful predictor of both large up and down days. As the following table illustrates, less than 31% of the worst days and less than 22% of the best days have occurred when the S&P 500 Index was above its 200-day moving average. Conversely, over 69% of the worst days and over 78% of the best days have occurred when the index was below its 200 day moving average.
S&P 500 Index: Best & Worst Days by Market Environment (September 1928-December 2010)
Putting It All Together
Managers who alter their exposure to stocks based on changing market environments can avoid the majority of extreme up and down days. Since large losses have a far greater impact on compounded returns than large gains, avoiding both extremes can have a significantly positive effect on long-term performance. As the table below indicates, not only can missing extreme days result in significantly higher returns than a static, buy and hold portfolio, but can also result in substantially less volatility.
S&P 500 Index: Returns by Market Environment, Price Only (September 1928- December, 2010)