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The Biggest Mistake You Can Make
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
February 14, 2008

"Why not bail out of stocks for the relative safety of high-yielding CDs?" That is a common question from investors grown weary of the market's nerve-racking ups and downs. However, understand that this volatility is more the long-term norm than we have come to expect during the past few years. Try to avoid emotional decisions based on movements in the market. Investors who make rash moves usually end up regretting them. Like many before them, these investors can fall into the single biggest trap in investing: trying to time the market.

At Schwab, we believe the most important decision you make with your portfolio is your strategic asset allocation—and sticking with it is key to long-term success. We strongly advise against making market-timing bets. But if you must, then it should be with just a small portion of your portfolio. (For more on the difference between strategic and tactical allocations, see Asset Allocation: The Long and the Short of It below).

But couldn't large shifts in your asset allocation improve your portfolio return? Theoretically, yes, assuming you could time market shifts correctly. The problem is that doing so consistently is close to impossible. Here's a look at why trying to beat the odds could deep-six your long-term investment plans—and a smarter alternative to consider.

Market bursts. The main factor working against market timing is that stock gains often come in quick, intense bursts. Miss enough of them and you lose all of the long-term advantages of owning stocks. Remember 2004? It was a good year for stocks, with the S&P 500® index returning 10.9%. However, the rise was hardly smooth. As the "Shock Treatment" graph below shows, from January through October 25 of that year, the S&P 500 was actually slightly down. Three-quarters of 2004's return came in the following 14 trading days! Predicting such sudden market turns requires an impossibly high degree of accuracy.

Opportunity lost. The opportunity cost can be substantial if you miss the best days by staying on the sidelines. During the past 10 years ending December 31, 2007, missing the best 10 days of the S&P 500 (that's 10 out of 2,517 total trading days) would have reduced your annual return from 5.9% to 1.1%—even less than the return of risk-free 30-day U.S. Treasury bills. Adding transaction costs would have reduced your return even further.

The pro's predicament. For market timing to be an effective investment strategy, you have to be right twice: once when you sell to exit the market, and again when you buy to re-enter. Being correct on the first call is challenging, but twice in a row is even more difficult. Although professional market timers—those who offer informed buy/sell advice to their clients—often claim success, decades of research have found little theoretical or empirical evidence that active market timing works. Indeed, a study that analyzed the five-year performance of 25 experienced professional timers found luck to be just as important as the timers' skill in determining performance results.¹ And while market timers can reduce portfolio volatility (simply by being out of the market for periods of time), researchers have found no evidence that they consistently boost returns.
Upward instinct. Since 1926, the S&P 500 has had a positive quarter 68% of the time. Just 15% of quarters had declines greater than 5%. As the graph below shows, over the long term, there have been many more ups than downs. Keeping some portion of your portfolio invested in the stock market throughout market cycles will let you reap the potent benefit of long-term capital growth.

Data from Morningstar Inc. through December 31, 2007. Quarterly S&P 500 Index returns include reinvested dividends. Each bar represents the count of returns greater than the number to the left but equal or less than the return labeled.

What you can do now
Now that you know not to risk your long-term wealth on large-scale, short-term moves in and out of the market, what can you do to best position your portfolio for the long term? Start by making sure that your strategic asset allocation plan reflects your risk tolerance and goals. And then stick with your plan.

As you can see in "The Power of Persistence" graph, returns can vary from year to year, depending on whether you chose a conservative, moderate or aggressive asset allocation. The difference in average annual returns between an aggressive portfolio (95% stocks) and a moderate one (60% stocks) was 0.9% over 38 years. Of course, compounding this seemingly small difference over many years can add up to a large amount. But that requires sticking with your allocation.

Data from Morningstar, Inc. Portfolio returns are 1970-2007.²

Take, for example, an aggressive investor with a $100,000 portfolio who panicked when stocks cratered in 2002 and reduced his equity allocation from 95% to 60%. If he then missed the 2003 rebound, his portfolio would have shrunk to $99,000, versus $108,000 at the end of 2003 if he had simply stuck with his plan. No matter what your long-term plan may be, sticking to it is critical.

Finally, focus on what you can and can't control. We can't control the markets, but we can control how we react to them. You've analyzed your long-term goals and built a portfolio intended to meet those goals. So fight the urge to make wholesale portfolio changes in a volatile market. Hang in there so you can be ready for the next upswing.

Asset Allocation: The Long and the Short of It

In investing as in life, it's easy to get distracted by short-term market moves, and lose focus on long-term goals. To keep that distinction clear, one can look at asset allocation through two lenses: strategic (long-term) and tactical (short-term). We believe every investor needs a strategic allocation, while tactical adjustments are optional—and should be used with restraint. If you just want to stick with your strategic plan, rebalancing as needed, you should be just fine.

Here's what we think about each type of asset allocation, and how you and a Schwab consultant can make these important concepts work for your portfolio.

Long-term (strategic) asset allocation
This is the single most important investment decision you can make. It's the mix of assets—stocks, bonds and cash—designed to grow your portfolio and meet your investment objectives based on your risk tolerance, investment horizon and unique preferences. A well-tailored strategic asset allocation plan also ensures diversification within asset classes to help reduce risk.

The vagaries of the market may shift your asset allocation (e.g., increasing your equity allocation in bull markets or decreasing it in bear markets). That's why we believe you should rebalance back to your strategic or target allocation at least annually. But that target should remain stable over time. In fact, we'd say you should adjust your strategic plan only when your personal circumstances change. For example, you might reduce your equity exposure slightly as you approach retirement.

Short-term (tactical) asset allocation
Tactical overweights and underweights to different asset classes or types of stocks and bonds are recommendations for modest adjustments to your strategic allocation, based on current market analysis.

Of course, it's difficult to know how long any near-term market move will last. That's why long-term investors can ignore short-term market action. If you have a shorter-term horizon and prefer to be more active, then consider keeping tactical shifts small (5–10% of your total portfolio, at most). Doing so distinguishes your tactical allocation from market timing, which can involve moving much larger pieces of your portfolio—and which we strongly discourage.

Important Disclosures

1. Carl J. Benning, "Prediction Skills of Real-World Market Timers," Journal of Portfolio Management, Winter 1997, pp. 55-63.
2. Data provided by Morningstar, Inc. Returns for 1970-2007 include reinvestment of dividends and interest, are rebalanced annually and are weighted averages of these indices: S&P 500® index (large-cap stocks), Russell 2000® index (small-cap stocks), MSCI EAFE Net of Taxes (international stocks), Lehman Brothers U.S. Aggregate Index (bonds), and Citigroup U.S. three-month Treasury Bills (cash). CRSP 6-8 was used for small-cap stocks prior to 1979, Ibbotson Intermediate-Term Government Bond index was used for bonds prior to 1976, and Ibbotson U.S. 30-day Treasury Bill index was used for cash prior to 1978. The aggressive allocation is 50% large-cap stocks, 20% small-cap stocks, 25% international stocks, and 5% cash. The moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds, and 5% cash. The conservative allocation is 15% large-cap stocks, 5% international stocks, 50% bonds, and 30% cash.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Certificates of deposit offer a fixed rate of return and are FDIC-insured.

The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

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