Markets will always have their volatile periods and no one can predict which weeks or months will generate good or bad returns and how long those periods will last. However, being out of the market for even short periods can markedly affect long-term portfolio performance.

We firmly believe in the concept of market efficiency, which we look at in other articles on our website, as well as the idea of the “random walk”.  The logic of the random walk is that if the flow of information is unimpeded, and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today.  But news is by definition unpredictable.  As a result, prices fully reflect known information and even uninformed investors buying a diversified portfolio will obtain a rate of return that matches that of the experts.

In his famous book “A Random Walk Down Wall Street” published in 1973, Burton Malkiel said that a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts.

The table below, taken from Fidelity International research shows the annualised returns over 15 years to the end of June 2009 of various different investment markets. The message is that it is very easy to get it wrong.

Average annualised returns (%) over 15 years – effect of missing best days

All figures show annualised, total returns, taken from 15 year periods, starting each consecutive months, from 30/06/2004 to 30/06/2009, in local currency terms. Source: Datastream as at 30/06/2009. Basis bid-bid with net income reinvested. These returns do not take into account initial fees.

Now, one could argue that if you missed the 10 or 40 worst days, you would significantly outperform the market and, of course, this is true. However, without a crystal ball, that is only possible with the benefit of hindsight. What the above figures show is that over the longer term, risk should be rewarded with higher returns but if you try to time the market, and get it wrong, those higher returns can easily be eroded.

If you compare the above figures with the same survey from a year ago, looking at the FTSE All Share numbers, the “fully invested” return was 8.89% p.a., the “best 10 days missed” return was 5.90% p.a. and the “best 40 days missed” return was 1.06% p.a. This is as good an indicator as any of how volatile markets have been over the past 12 months.

Our preference is to recommend a buy and hold strategy but to rebalance this portfolio at regular intervals to try to keep it close to the target asset allocation. In practice, what this means is getting into a habit of buying low and selling high. Where practical, we believe that it also makes sense to spread lump sum investments over a number of stages at monthly, quarterly or even longer intervals to reduce market timing risk.