Does the law of gravity apply to financial markets?

The original version of this article first appeared in The Business Times.

As they say, "What goes up, must come down." But do gravity and the laws of physics apply to financial markets?

As markets power ahead to new highs, questions commonly arise from investors. Although we are a digital platform, as an independent financial adviser we interact with many investors daily of varying ages, gender, income levels and financial knowledge. However, the most commonly asked questions are the same. Here are a couple: Is the market at its peak? Is it the right time to invest?

When there is an opportunity to interact directly with clients, I often ask a question in response - What do you think happens to the market after it hits an all-time high? Almost always their answer is - it will fall.

You can see the logic behind this - when we hear the words "peak" and "all-time high" the human brain thinks for some reason that the law of gravity applies to financial markets and responds in a contrarian way. We even hear this type of phrase used commonly - "what goes up must come down" even though the law of gravity is not, the last time I checked, a commonly taught financial theory.

It is just a bad idea to apply the laws of physics in the wrong field where they do not apply. It often causes us to make the wrong behavioural decisions and hold false beliefs, often based on unproven evidence or wrong assumptions, and this hinders us from achieving good outcomes. We need a fact check.

Empirical evidence from historical data tells us a very different story about how markets behave during and around all-time highs. Normally the markets, after peaking, probabilistically would go on to make another all-time high. In fact in the past decade, the markets on average hit all-time highs around 35 times per year. Considering that there are around 250 trading days a year, this is a stunning 14% of total trading days where the market makes an all-time high (using the S&P 500 index).

One can argue that this follows an amazing streak of 13 years since the Global Financial Crisis where the markets continued to generate annual returns that were positive for every year bar one. However, we have to remember that we had major falls in markets - 20% in 2018 and over 30% in 2020, which are often seen as bear markets. As the accompanying chart shows, it has not been smooth sailing. In every year but two, we have had a major correction of more than 5%, and more than 10% in eight of the 13 years. So drawdowns are also a common occurrence.

The problem arises when people focus way too much time and attention fearing the intra-year falls even though they are temporary. What would have happened if you had just forgotten about it and invested at the beginning of the year, and checked on it at the end of the year? The market would have been up every single year in those 13 years except one and in that one year the market fell only 4.4%.

Each correction would have been an opportunity to continue to dollar-cost average into the market and not a reason to sell. The problem with trying to time the market is that we have to get two decisions right - when to sell and then the even harder decision is when to re-enter the market at a lower price than when you sold it. But if the market maintains an upward trajectory then you will never be able to buy it back below your selling point, or just never re-enter at all which is a painful mistake that nobody wants to make.

Sell in May and go away?

Another popular question is — Is this a good time to invest? Investors ask this because they want to try to pick the right week, month or season to invest. They are constantly trying to figure out a way to time the market. When people talk about seasonality in markets, it reminds me of the famous Mark Twain quote. "August: This is one of the peculiarly dangerous months to speculate in stocks. The others are October, January, September, April, November, May, March, June, December, July and February." But apart from the fact that markets by definition have volatility and risk, how we invest makes a difference. Mark Twain warns against speculation.

Another commonly used phrase is "sell in May and go away". But does this strategy of selling in May and going away before coming back in November actually work? The fact of the matter is that any investment strategy that can be summed up in a short rhyme is probably not a good one.

In fact, in just the past two years (2019 and 2020), had you sold in May, you would have missed out on two of the best periods of market returns historically. But this year may be different (as someone would say) so let's again look back in history and see what markets have actually done.

The actual historical performance of markets between 1945 and 2020 shows that between November and April, the markets did perform better with 5.2% return, versus May to October which averaged 2.1%. So on the surface, the adage is based on facts. However, if you stayed invested for the full year and did not trade the seasonality, you would have gotten a 7.3% return (using the Dow Jones with the longest history).

Compounding

In fact, this may not seem like much of a difference, but if you invested $1 million during May to October and held on to cash for the remainder of the year, you would have ended up with $47 million. But if you had chosen not to do anything and left it in the markets without touching it throughout the year, then it would have compounded to a phenomenal $211 million.

Avoiding the short-term falls and trading the seasonality may sometimes work. But the evidence suggests that not only is every year different, but that staying invested over the long term has always generated better outcomes. That's why this column is called the Science of Wealth: Financial markets are governed by evidence and scientific data. We should not apply the laws of physics or climatology to finance, and should not act on common investing adages that can lead to poor outcomes. Focus on being steadfast on time in the market, instead of timing the market.

Read more: The power of compound interest explained

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