The Folly Of Trying To Time The Market

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Recent fits and starts in the stock market prompt us to visit a topic we spent a few pages on in our book but have yet to tackle in a Mind Over Money post. Three topics, really, but we’ll tackle two of them in follow-up posts: Today’s subject is market timing, i.e., pulling money out of stocks when share prices seem poised for a protracted fall (or long sojourn in the doldrums) in the hopes of reinvesting when prospects improve. Great idea — Sell high! Buy low! — except for two points: 1) it’s a fool’s game; and 2) there’s a huge cost to trying.

Allow us to explain. Three quarters of a century’s worth of reliable data has demonstrated that no one can predict, with both accuracy and consistency, which way stock prices are headed. Doesn’t matter whose results you study — hedge fund gurus, mutual fund managers, academic researchers, fortune tellers — they’re all just guessing, in one form or another, and sooner or later their theories or hunches are undone by reality.

Yes, some have good results, even for a stretch, but it’s no different than if you assembled 1,000 people in a gym, gave each a penny, then asked everyone to flip their coin and leave the building if it comes up “tails.” After Round 1, roughly 500 people will be left. After Round 2, approximately 250 will remain. Flip five more times and half a dozen people will still be in the gym. Now ask yourself: Are these people especially skilled at flipping “heads” or is their streak simply a reflection of chance?

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That’s how you have to view the market-timing game, especially if you’re the one playing it. Untold amateur and professional investors have tried — using various combinations of historical data, hunches, economic theory, social science research, technical analysis, even weather patterns — and for a while some look like they know what they’re doing. But over time, all have proved (or will prove) to be little more than coin-flippers. Markets are simply too dynamic and complex to predict with reliable consistency, not unlike the weather: You can forecast broad trends somewhat accurately, but day-to-day certainties are impossible to come by.

But some might ask: What’s so bad about that? Meteorologists today are pretty accurate, save for the occasional unexpected rainstorm or blizzard that never came. That leads us to our second point. In the stock market, the occasional occurrences are the crucial occurrences. Get the weather forecast wrong one day and maybe you’ll end up soaked. Get market timing wrong and you’re likely to miss big gains. That’s because “the market” earns most of its major gains in short sunbursts.

Consider some research by finance professor H. Nejat Seyhun: If you had missed the 90 best-performing days of the stock market from 1963 to 2004, your average annual return would have dropped from about 11% to a little more than 3%. More than two-thirds of the market’s gain during those four decades happened in fewer than 1% of  its trading days. That’s doesn’t leave much room for errors in market timing. We were reminded of Seyhun’s research a few weeks back when the broad market had an exceptionally strong run of days at the end of June and in early July, rising better than 5%. Such spikes are at the same time common and unusual. They happen regularly but not in any way you can predict. And market-timers who jumped back in after that rally have been rewarded with … falling prices.

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This is why most experts recommend that individual investors settle on the portion of their portfolio that they want in stocks and stick with it (rebalancing once or twice a year at most). Yes, you’ll suffer inevitable dips in prices. But you’ll also benefit on those unpredictable days when a drizzly market suddenly brightens. You can’t get a tan if you’re not in the sun.