The Power of Compounding: Time in the Market vs. Timing the Market
Introduction
Many investors think the key to success is timing the market by making the right moves at the right time, however this is difficult even for experts and it comes with many risks. Investors should instead focus on time in the market.
Time in the Market
The “time in the market” approach focuses on staying invested regardless of short-term price fluctuations. It leverages the power of compounding and the historical upward trend of markets over time. There are several benefits of staying invested.
- The Power of Compounding – Staying invested, reinvesting dividends and earnings accelerates portfolio growth. Long-term investors will benefit from compounding returns that outweigh any short-term volatility.
- Reduced Risk Over Time – While short-term market movements can be volatile, markets generally rise over the long run thanks to the risk premium that compensates investors for taking risk. The longer we stay in the market, the lower the risk of negative returns.
- Avoiding Emotional Investing – A long-term focus reduces the risk of making impulsive decisions based on short-term market movements. A disciplined, long-term approach helps avoid panic selling during market downturns and overenthusiastic buying in stable markets.
The Power of Compounding
Compounding is the process whereby investment returns generate additional returns over time. The longer money remains invested, the more significant the potential compounding effect.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”
Albert Einstein
To illustrate the power of compounding as well as the risk associated with market timing, it helps to look at the long-term return of an index like S&P500. A $1000 investment in the S&P500 20 years ago would have been worth $7320 by the end of May 2025. An investor that missed the 10 best days during those 20 years would have seen the value of the $1000 investment increase to only $3257. Consequently, as illustrated in Chart 1, missing the 10 best days over the last 20 years cuts long-term returns by over 50%.
Chart 1: S&P500 Total Return With and Without 10 Best Days[1]
Source: Bloomberg, NBKW CIO-Office Analysis
Risk Premium adds to Long-Term Returns
Investors are compensated for taking risks through what is known as the risk premium, i.e. the additional return expected from riskier assets, such as stocks, compared to holding low risk assets like cash or government bonds. While there are no guarantees when investing, the probability of risk being rewarded over time is much higher compared to the probability of the market going up or down over the next 3 months.
Timing the Market – A Risky Strategy
There are several challenges associated with trying to time the market that makes it a risky approach.
- Difficult to Predict Markets Accurately – Short-term market movements are very hard to forecast because they depend on unpredictable factors like geopolitical crises, economic data releases and investor sentiment.
- Emotional Decision Making – Many investors are influenced by emotions like fear and greed. They tend to buy when markets feel stable and sell when volatility rises. This behavior often leads to buying high and selling low, which can destroy value in a portfolio. Missing just a few of the market’s best-performing days can significantly reduce long-term returns.
- Opportunity Cost – Staying out of the market while waiting for the “perfect” moment means missing out on potential gains from rising stock prices and dividends. This opportunity cost can hurt the long-term growth of a portfolio.
- Increased Trading Cost and Taxes – Frequent buying and selling increases transaction costs and may trigger capital gains taxes both of which reduce net returns.
Historical Evidence Supporting Time in the Market
Equity markets have historically delivered positive returns over the long term, despite short-term market volatility. For example, during the 2008 Financial Crisis, markets lost nearly 50% but recovered to new highs within a few years. Similarly, after the sharp drop in the COVID-19 crash of 2020, markets rebounded within months. These examples show that long-term investors who stayed invested benefited from strong recoveries.
Chart 2 shows the FTSE All-Share Index’s calendar-year returns and largest intra-year losses over 40 years. Despite average intra-year declines of 15%, annual returns were positive in 28 out of those 40 years, highlighting that staying invested helped investors recover from short-term declines.
Chart 2: FTSE All-Share Intra-Year Declines vs. Calendar-Year Returns[3]
Source: JPMAM, Bloomberg
Stay Invested – Keep Investing and Diversify
Trying to predict short-term market movements is extremely difficult. A better approach is to invest regularly over time using dollar cost averaging, investing a fixed amount at set intervals regardless of market conditions. This reduces the risk of investing a large sum at the wrong time and smooths out market volatility.
Investors should also maintain diversification across assets like stocks, bonds and alternative investments to reduce exposure to any single market downturn. Finally, regularly rebalancing a portfolio ensures that it stays aligned with the investor’s risk tolerance and financial goals.
Key Considerations Time in The Market vs. Timing the Market
- While market timing may seem attractive, it is very difficult to consistently predict price movements, with a significant risk of making poor decisions driven by emotions.
- The Power of Compounding makes a compelling case for prioritizing “time in the market” over “timing the market”.
- Historical Evidence supports the long-term benefits of staying invested.
Successful investing does not require perfect timing – it requires patience, discipline, and time. By staying invested, applying consistent strategies like dollar-cost-averaging, appropriate diversification and rebalancing, investors are more likely to reach favorable investment outcomes.
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