How 'timing drag' chips away at portfolios
Living a financially free life can vary from one person to the next.
Some people may want to travel the world. Some may want to give back to charity. And then some are content with just being able to cover an unexpected expense.
No matter what it means to you, investing is the best path to reaching that goal. But when the market experiences a downturn and uncertainty sets in, it is natural for some to doubt whether they will reach their goals. They may tinker with their investment plan or pull out of the market to stem losses.
Keeping emotions in check can help lead to financial freedom and a reduced chance of losing that freedom in the future.
To illustrate, we adjust portfolio returns by the average “timing drag” to see how much a meddlesome approach impacts investors’ retirement goals.
The uncertainty that comes with market turbulence often tempts investors to change or even abandon their investment strategies. However, many studies show the persistent difficulty investors have when attempting to time the market. Since 1994, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) has measured the effects of investor decisions to buy, sell, and switch in and out of investment funds. The DALBAR results suggest that the average investor would be better off holding an index or mutual fund than “trading” the same funds, a phenomena we refer to as “timing drag.” Over the most recent 30-year period ending in Dec 2020, timing drag lost investors 4.5% annualized for equity portfolios and 5.4% for fixed income portfolios. This data, and many other studies, shows that attempting to time the market slowly chips away at investors' wealth.
Exhibit 1: Average investor vs the market timers
30 Year period from 1990 to 2020
It is important to understand the implications of “timing drag” on financial planning. Investors saving for retirement, or any other financial goal, should consider that most financial plans assume you will stay invested and not time the market.
In constructing a plan, an advisor typically draws on the long-term expectations of risk and return characteristics for eligible asset classes. Attempting to time the market would have a substantially negative impact on an investor’s financial plan.
Take retirement planning, for example. Even though the notion of retirement has evolved and more clients want financial freedom than anything else, an advisor is effectively trying to solve for three questions:
When can I stop working?
Will I outlive my money?
How much can I spend in retirement?
We will answer each question using historical market returns and the average “timing drag” realized due to failed market timing.
Every investor planning for retirement asks this question. How much do I need to save before I can stop working?
For simplicity let us assume an investor saves the current 401k maximum of $19,500 at the beginning of each year and they want $2,000,000 saved before retirement. Using the market returns and average investor returns of the last 30 years, we can see how much of an effect the “timing drag” will have on the investors ability to hit their $2,000,000 target. (Exhibit 2).
Exhibit 2: Total saved by contributing $19,500 annually
In this example, it takes an investor eight additional years to retire and hit their target number if they experienced the average timing drag vs the average market return. Waiting an extra 8 years until you can stop working or spend your time as you want is a high cost to pay for anyone.
The “4% Rule” illustrates the likelihood of having enough money to last in retirement. The debate about the 4% Rule is ongoing, but for the purposes of illustrating the detrimental effects of market timing drag on a retiree’s goals, this rule provides a good case study.
For background, "The 4% Rule" refers to a commonly researched scenario in the study of determining a safe withdrawal rate from retirement portfolios of both stocks and bonds. In this case, the portfolio is 50% equities and 50% bonds, and the retiree withdraws 4% of the portfolio value in the first year of retirement and then withdraws the same amount adjusted for inflation in subsequent years to maintain their standard of living. The standard study assumes the portfolio needs to last thirty years and results are compared by using the probability that the portfolio will not be exhausted in less than thirty years. Using historical returns as a guide to determine which withdrawal rate has an acceptably low probability of failure is how the 4% rule was born.
For our example, we will assume our investor from earlier was able to hit the $2,000,000 target and they want to follow the 4% rule with a 50/50 portfolio of stocks and bonds. In the first year, they will withdraw $80,000, and then in year two, $80,000 adjusted for inflation.
We have about 150 years of equity and bond data so we can look historically and determine what percent of the rolling 30-year periods this investor would not run out of money using the 4% rule. The data begins in 1871 and ends in 2019, equaling 119 rolling 30-year periods. We can use the 4% withdrawal rate, combined with market performance data, to determine the frequency of historical periods in which our hypothetical investor would run out of money.
There is only one 30-year period since 1871 when an investor would have run out of money. That translates to about a 99.2% chance an investor will have enough money to last for 30 years.
If we redid the exercise, but this time, we add the average “timing drag” to both equities and bonds while holding all else equal, the number of 30-year periods where an investor runs out of money increases to 101 of the 119 periods, which translates to only a 15.1% chance an investor will have enough money to last for 30 years.
The decrease in the likelihood of an investors' money lasting for 30 years from 99.2% down to 15.1% comes down to “timing drag”. Any drag on market returns creates a higher likelihood of running out of money during retirement.
Exhibit 3: Historical success rate of a 4% withdrawal rate
30 Years, Inflation Adjusted, 1871-2019
We can use historical data to help answer this question. In this case, instead of looking at the percent of success or failure at different withdrawal rates, we can look historically at every 30-year period and, with the benefit of hindsight, calculate what is the maximum withdrawal rate a retiree could have made over that period. The maximum withdrawal rate is the highest amount that a retiree could withdraw annually and not run out of money by the end of the 30-year retirement period. The graph below shows this analysis using a 50/50 equity and bond allocation and shows both a scenario where the investor achieves the market rate of return and a scenario where the investor achieves the market return minus the “timing drag.” It is no surprise that the amount the investor could spend in retirement is substantially reduced if they experienced the average “timing drag.”
Exhibit 4: Maximum allowed withdrawal rate for each 30 year period
50/50 stock and bond portfolio
Another way to frame these results is to determine what withdrawal rate would have guaranteed that a hypothetical investor would not have run out of money. If the investor received average market returns, this amount is roughly 3.9%. However, if the investor’s portfolio’s return was reduced by the average “timing drag,” the withdrawal rate for guaranteed success drops to 1.9%. For an investor with $2,000,000 saved for retirement, their annual retirement spending drops from $78,000 per year to $38,000 per year with the implied “timing drag.” This represents a substantial standard of living decrease for our retiree.
Investors often hire an advisor to help them achieve financial freedom—the freedom to spend their time the way they want. One of the most important things that advisors can do to make this a reality is to limit behavior that slows down investor’s portfolio growth and thereby extends the amount of time it takes for them to achieve their financial goals.
Technology and automation reinforces your efforts by systematically ensuring that investment portfolios match each investor's unique risk tolerance, goals, and investment horizons.
The data is clear: on average, investors that attempt to time markets end up with lower returns than those armed with a plan and technology that help them stay the course. A “timing drag” can adversely affect when retirees can retire, how much they can spend in retirement, and can increase the chances they run out of money. With planning and a little self awareness, investors have a better chance of avoiding those pitfalls on the road to a successful retirement.
Travis Fairchild is a senior investment strategist at Vise
September 8, 2021