How to Make Money in the Stock Market, Re-Revisited

In the comments to my post on how to make money in the stock market, Jonathan pointed out another post on the same topic, but with a different slant.

In short, The Finance Buff argued that the odds of missing the 10 best days over 20 years are so slim that stats such those that I presented in my original article (as well as in my followup) are meaningless. I’ll be the first to admit that my view is something of an oversimplification, but so is TFB’s contrary view.

Indeed, while the odds of missing the 10 best days (and those days alone) may be many, many billions to one, it’s incredibly important to keep in mind that the very best days in the market are not randomly distributed. Rather, they’re often clustered in the wake of major drops in the market. This makes it especially likely that the unseasoned investor will react to bad news (e.g., a huge drop) by selling their holdings, and then miss the rally on the other side. Thus, by the time they buy back in, they’ll have locked in their loss.

I’ll be the first to admit that TFB did a great job of dissecting the numbers. However, I remain unswayed in my opinion that, for the average investor, the best way to deal with market volatility is to sit tight and ride it out (actually, I think TFB agrees with this latter point).

Taking Black Monday as an example, the crux of the counter-argument is that those extremely hot days (gains of 9.3%, 5.3% and 4.9%) that happened in the week and a half following the crash were mixed with moderate losses. Because the only way to realistically capture those gains was to also endure mixed performance on the intervening days, the net gain over that week and a half would’ve been 8.8% instead of (1 + 5.33%) * (1 + 9.10%) * (1 + 4.93%) – 1 = 20.6%. This is undoubtedly true, and it clearly reduces costs associated with missing those days. TFB further argues that if someone had sold at market bottom and then remained on the sidelines until December 3, 1987, they would’ve been able to re-enter the market without losing a dime.

I take no exception to any of these numbers. What concerns me the most here is investor psychology. Indeed, if someone is inclined to liquidate their holdings in the wake of a market crash, it’s unlikely that they’re going to be dispassionate enough to sit on the sidelines after the rally begins, waiting until the market to fall back to even money (if it ever does). I would argue that an investor that gets scared and sells in the wake of a market bloodbath will be especially likely to panic on the other side and jump back in after seeing the market shoot back up.

Moreover, in a market whose overall trajectory is upward (as is the case with ours), there are no guarantees that it will ever fall back to the point that you’ll be able to re-enter at even money if you miss out on the initial rally. Are the numbers from the “10 Best Days” argument overblown? Absolutely. But look at it this way… Had you panicked on Black Monday and sold at or near the bottom, then gotten your nerve back and bought back in a couple weeks later when the market had rallied, you still would’ve locked in an 8.8% loss.

Note that this entire discussion also ignores tax issues and trading costs, both of which tilt the playing field even more in favor of a buy and hold strategy. Indeed, if you bought your shares way back in the day, it’s very possible that selling following a drop from recent highs will result in the posting of long-term capital gain (i.e., you’ve lost money from recent highs, but actually gained since you originally bought the shares years ago). Thus, you’ll not only shave a decent chunk of your return off the top if your timing is off, but you’ll also expose yourself to a tax liability that wouldn’t otherwise exist.

The fact of the matter is that, for the average investor, decisions on whether to jump in or out of the market are little more than a guess. Sometimes you’ll be right but, on average, you’ll be wrong. While arguments based on missing out on the X best (or worst) days oversimplify things and give you a worst case scenario, I still consider them to be instructive.