The market timing illusion: Why sitting on cash can be a costly mistake

Avoid the heavy opportunity costs of missing market rallies.

When markets become unpredictable, it feels natural to want to move your money into cash, like finding safety during a storm. However, in investing, this choice often ends up being a mistake.

Let’s understand why moving your money to cash not only fails to protect your wealth but can reduce it over time.

1. The myth of market timing

Market timing is like catching lightning in a bottle. The idea sounds appealing: sell at the peak, buy at the bottom, and repeat.

Why timing the market is a losing game

Timing the markets is notoriously difficult - even for seasoned investors:

• Legendary investors like Michael Burry and Bill Ackman have made headlines for calling market crises but have struggled to replicate such success consistently.

Also read | Investing in mutual funds through an SIP? Here are some key do's and don'ts

• The equity curve below shows that missing just the top 20 market days in a 34-year period can halve your returns. Think about that: a handful of days can make or break decades of wealth creation.

The following chart demonstrates how missing just the top-performing days in the market significantly impacts long-term returns. With over 8,500 trading days analysed, see how the CAGR shifts when these top days are excluded.

Why perfect timing is impossible

Successful market timing requires two correct decisions: when to exit and when to re-enter. If we assume you have a 50 percent chance of being right on each decision (an optimistic assumption), the probability of being right on both decisions is just 25 percent. Make these decisions multiple times, and your odds of sustained success plummet further.

Consider that to successfully time the market over a 10-year period, making just two timing decisions per year, you would need to be right 20 times in a row. The probability of getting all these decisions correct, even with a 50 percent success rate per decision, is less than 0.0001 percent.

"Time in the market beats timing the market”. This isn’t just a catchy phrase; it’s the cold, hard truth.

2. The behavioural trap

Investing isn’t just about numbers; it’s about psychology. And sitting on cash is often a behavioural trap. Here’s how:

The illusion of being ‘right’ but gaining nothing:

• An investor sells their portfolio at $100, anticipating a 25 percent market correction. Instead, the market rallies 33.34 percent to $133.34 before eventually correcting back to $100, as predicted.

• This highlights a key flaw in market timing: it is not enough to predict corrections accurately; you must also time your call perfectly. The costs of being wrong—even temporarily—can significantly outweigh the benefits, proving that staying invested is often the wiser choice.

The fear of catching a falling knife:

• An investor sells at $100, anticipating a market correction. When the price drops to $90, they hesitate to re-enter, fearing further declines to $80. By the time the market recovers to $110, they’ve missed the optimal re-entry point and struggle to buy back at a price higher than their original sale.

Also read | ICICI Pru CIO warns on small-caps, mid-caps: Is it time to exit SIPs in these funds?

"More money is lost preparing for corrections than in the corrections themselves." Peter Lynch’s words couldn’t be more relevant.

3. The hidden costs

Taxes – Realising certainty to hedge uncertainty:

• Selling investments too quickly triggers short-term capital gains taxes, significantly reducing portfolio value.

• Example: Selling a portfolio worth Rs 500,000 with a Rs 200,000 gain at a 20 percent tax rate means paying Rs 40,000 in taxes, reducing the portfolio to Rs 460,000—a direct 8 percent hit to your wealth.

Opportunity costs – Missing out on market growth:

• Timing the market often means sitting on cash during rallies, missing out on compounding gains.

• While waiting for the "perfect" entry point, investors forgo dividends, reinvestment opportunities, and long-term growth, which can be far more costly than a short-term loss.

Derivatives: Misunderstood but powerful

Many people think of derivatives as tools for risky speculation, but they were originally designed as a shield against uncertainty—a way to hedge risk.

Take options, for example. Think of them like an insurance policy for your portfolio.

You pay a premium, just like you would for any insurance. If the market falls, the option "pays out," protecting your portfolio from losses. But if the market rises, you don’t lose everything—you just forfeit the premium.

It’s a small cost to safeguard against big corrections, offering peace of mind and stability in volatile markets. Derivatives, when used wisely, are not about betting—they’re about protection.

We have conducted a backtest to evaluate the effectiveness of using put options to protect an investment portfolio that includes the Nifty index as underlying. Each month, we purchased put options costing between ~1 percent and 2 percent of the portfolio's total value.

The drawdown curve below compares a portfolio hedged with monthly Nifty puts against an unhedged NIFTY portfolio.

• Reduced drawdowns: Hedging with puts significantly reduces drawdowns, not just during major crashes but across various market corrections.

• The cost of protection: This protection comes at a modest cost of 1-2 percent, akin to an insurance premium.

Hedging with puts is most effective when your portfolio has a high correlation with Nifty. This analysis consists of monthly puts that are rolled over consistently to maintain protection.

Cash calls versus hedging: Lessons from Nifty’s history

When investors take a cash call—selling their portfolio in anticipation of a market correction—three outcomes are possible: the market can rally, crash, or move sideways. While this may seem like a simple decision, the consequences of being wrong can be severe. Let’s explore what 15 years of Nifty data reveals about this choice and why hedging with derivatives often outshines moving to cash.

Cash versus hedged portfolios

We compared two strategies over 15 years:

1. Cash portfolio: Represents an investor who exits the market entirely and holds cash.

2. Hedged portfolio: Represents an investor who stays invested while using Nifty puts to hedge against downside risks

Below there is a scatter plot which, shows all the times a hedged portfolio outperforms a cash portfolio.

Table 5: Comparison of cash portfolio versus hedged portfolio

Here’s what the data revealed:

When markets rallied:

The hedged portfolio dominated the cash portfolio. While the cash investor suffered heavy opportunity costs by missing the rally, the hedged portfolio retained most of the gains, minus the cost of the put premium. This makes hedging a clear winner in the top left quadrant of our analysis, where markets moved upward.

When markets crashed:

Both strategies protected the portfolio. The cash portfolio performed slightly better than the hedged portfolio, as the put premium added a minor cost. However, the protection offered by the hedged portfolio was still significant.

The history of Nifty over the past 34 years shows that, in any given year, the market trends upwards of 72 percent of the time. This means that markets are far more likely to rise than fall, making a bold cash call a risky gamble.

Even scarier: For a cash call to be justified, the market must correct by 25-30 percent. Yet, such steep corrections have historically occurred in only 1 percent of cases. This means that while major corrections may seem daunting, the probability of missing out on market gains is much higher.

The takeaway: Stay invested, Hedge the risks

Instead of trying to time the market, the best strategy is to stay invested and use derivatives, to hedge against downside risks. This approach allows you to:

• Avoid the heavy opportunity costs of missing market rallies

• Protect your portfolio during market corrections

Also read | This too shall pass: How to navigate market movements in turbulent times

• Retain the long-term gains that equity markets provide

By remaining invested and managing volatility with hedges, you can navigate the ups and downs of the market without paying the hefty price of being wrong. In the end, the key to long-term success is not timing the market—it’s time in the market.

The writer is Partner and Fund Manager at Qode Advisors

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.