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Timing the Market is a Loser’s Game: What We Can Learn from Dollar-Weighted Returns

If you’ve ever had any thoughts about trying to time the market, I’d suggest first doing some research into dollar-weighted returns and what they tell us.

What Are Dollar-Weighted Returns?

Almost without exception, when you read about the return that a fund earned over a period of time, you’re reading about time-weighted returns. Time-weighted returns answer the question, “If I invested $1 at the beginning of the period in question, what return would I have earned on that $1 over the period?”

Dollar-weighted returns answer the question, “What did the average dollar invested in this fund earn over the period in question?” In other words, if a fund grows from year to year (by more people investing money in it), each successive year will be weighted more heavily in the calculation of dollar-weighted returns.

In essence, what dollar-weighted returns show us is what the average investor in the fund actually earned over the period.

Pretty cool stuff, eh? Unfortunately, most fund companies don’t show us the dollar-weighted returns that their funds earned. Why do we suppose that is?

Dollar-Weighted Returns Are Almost Always Lower

For the most part, dollar-weighted returns of a fund are significantly lower than time-weighted returns. (In fact, I have yet to see a single situation in which a fund had a higher dollar-weighted return.)  Why is that? It’s because people (on average) tend to throw money into a fund after a good year and pull money out after a bad year. People try and time the market, and people lose.

But that’s only with individual funds. What happens when we take a look at the market overall? Interestingly enough, the same thing happens. According to a study done a few years back by Ilia Dichev (an Accounting professor at the University of Michigan), the time-weighted return of the market from 1926-2002 was 10% per year. The dollar-weighted return, on the other hand, was only 8.6%. That means that on average, everybody underperformed the market by 1.4% per year (not including investment costs).

This may seem counter-intuitive, as it seems that–in the aggregate–investors’ performance must match that of the entire market. Unfortunately, that’s not quite true. The reason for this aggregate underperformance is that companies tend to issue new shares of stock when the market is up, and they tend to buy back shares of their stock when the market is down.

So what’s the lesson?

My takeway is that I think I’ll stick with Oblivious Investing: Investing regularly into diversified mutual funds and passing on any attempts to time the market.

What are your thoughts? Have you ever tried to time the market? And if so, how’d you do?

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Comments

  1. I didn’t intend to time the market, but my life is timing it for me!

    And I’m afraid I’m going to lose.

    I was earning a lot in the last few years, and investing heavily into mutual funds.

    I quit my job a few months ago to have a baby, and now my husband and I don’t have extra money each month to invest.

    This freaks me out, because we bought most of our investments at a high cost per share. And instead of buying more shares with our money now that the market is down, we’re basically not investing anymore.

    What do you recommend for someone in my situation?

  2. Great question Kathy.

    I can see why you’re concerned, having purchased at a market high point and now (when things are a bargain) not having the cash flow available to take advantage of it.

    What I’d say is this: Of course, do your best to try and minimize expenses to free up some cash flow to invest. And beyond that, there’s no sense in worrying.

    You already know that the answer is not to take your money out. You also know that you’re looking at many many more years for your money to grow (after it recovers to where it once was).

    In short, invest what you can. Beyond that, don’t worry about it.

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