Dan doesn’t like to waste time. He’s always multi-tasking to get as much done in a day as he can. It’s just as well, because his job in technology has him in perpetual motion. He wouldn’t have it any other way. Dan likes to be active with his investing too. He’s always assumed that he can pick when to get in and when to get out of the equity market. But recently he’s started to doubt that he’s been doing the right thing.
After sitting in bonds for the best part of six months, late last year Dan switched most of his portfolio back into stocks because the market had been doing so well. Three weeks after he loaded up, the stock market sold off hard on rising inflation worries. He stood firm through a 5% percent decline. He gritted his teeth as the correction pushed past 10%. But by the time the stock market declined 15% he decided he couldn’t take the pain anymore, so he sold his stocks and bought bonds again. The relief was short lived. A few weeks later, the worries about inflation ebbed and the equity market rebounded strongly. Stocks gained back all they had lost in the prior months and reached new all-time highs soon after. Dan felt sick. And angry. Now he was losing out again. What had he missed? Why weren’t his bets working?
This experience is called “market timing”, and it’s one of the best ways to destroy your financial security.
Market Timing is a Common Trap
Market timing is alluring because, at first glance, it seems obvious that any intelligent person should be able to make a judgement as to when it’s an appropriate time to buy or sell stocks. If we listen to the news, financial pundits, and other “experts,” we should be able to have a good feel for what to do next. If the economy seems shaky: sell! If it’s going gangbusters: buy! If we could just sidestep all those bear markets, and then get back into the market when it’s about to rebound back to a bull market, we’d be golden.
Alas, it’s not as simple as that. People who study markets all their lives, with armfuls of PhDs and bucketloads of research dollars, have yet to come up with a system that works for future events and not just retrospectively. So how are part-time amateurs going to succeed where the professionals failed? I want you to put your common-sense hat on before you answer that one!
It’s Human to Want to Time the Market
Market timing appeals to the tendency of most people to be overconfident. Numerous studies have demonstrated our tendency for overconfidence, be it student self-assessments of how they think they will do academically versus peers, how drivers compare themselves to other drivers, or what investors think their chances are of outwitting other investors. Research also suggests that those least likely to outperform peers are often the most overconfident, with those most likely to outperform peers the least overconfident. Perhaps nature has endowed us with this optimistic view of life to help us survive as a species. Unfortunately, it does not help us succeed as investors.
Other human tendencies make accurate assessment of the prospects for investment markets exceedingly difficult. The first of these is apophenia: the tendency to see patterns in data where none exist. Then there’s the irrational primacy effect, which describes how we ascribe greater weight to information encountered earlier in a discovery process than later. And finally, confirmation bias references our tendency to gather, interpret or remember information that confirms our pre-existing beliefs or hypotheses.
The Data is Clear
Numerous studies show that investors underperform indexes as a group, partly due to attempts at market timing. I’ve presented in depth on this topic here. Research by Dimensional Fund Advisors—a large investment manager—found that being out of the stock market even for short periods can severely reduce investor returns. For S&P 500 data from 1990 to 2017, missing the single best five trading days each year cut average annual return by 1.60%, from 9.81% to 8.21%. Missing the 25 best days cut average annual return by more than half to 4.53%. And this doesn’t factor in other headwinds from active trading, such as higher commission costs and capital gains taxes.
The odds that you’ll be better off being out of the market are stacked against you from the outset because equity markets increase more often than they decrease. And this effect becomes even more emphatic the longer the holding period. For example, the S&P 500 index has increased on 51-55% of trading days, depending on the era examined. If we extend the investment period to calendar years, the S&P 500 has increased in 68 of the last 92 years (74%). If we take rolling 50-year periods between 1926 and 2017, the “up” year percentages vary between 64% and 80%.
Data on markets reveal that investors, market cycle after market cycle, sell heavily at or near the bottom of bear markets and pile into stocks when everyone is bullish. Despite our rational brain knowing that stock market downturns in the United States have, and should continue to be, only temporary, our irrational brain can get the better of us during these periods. That’s what fear does to us. In every bear market investors commonly ask: “what if the market doesn’t recover?”
What to Do Instead of Market Timing
Rather than trying to outwit a market consisting of many thousands of very smart and dedicated investors who follow every possible data point and put their money where their mouths are every day, embrace the certainty that a bear market will, eventually, arrive. But prepare for it now by thinking long and hard about how much portfolio downside you could stomach without incurring sleepless nights. Then adjust your level of high quality bonds to calibrate potential downside to an acceptable level.
Staying invested, with exposure to non-correlated assets to cushion bear markets, is the way to go. Gold, the Japanese yen, and Treasury bonds all fit the bill. However, only Treasurys pay an income while also being cheap and easy to in which to invest. Gold and yen are also subject to other factors that are best left to professional investors.
There are many other aspects of your life to consider when deciding what kind of portfolio you can live with through tough times. For some investors a large mortgage can cause them to panic during a market downturn. This happens when funds mentally marked for eventual mortgage paydown are first invested in the stock market, because it strips the investor of the ability to be patient when stocks inevitably go through a rough patch. An investment portfolio funded by mortgage debt is a leveraged investment!
Similarly, an imminent need to liquidate part of a portfolio for another purpose can affect the investor’s psychological fortitude. Other commitments, such as college funding, leveraged local real estate investments, and large assets that plummet in value and liquidity during tough times, such as pleasure boats, can also crimp our tolerance for temporary portfolio downside.
A good fee-only fiduciary advisor can help you think through these issues so that you can reap the miracle of equity market wealth compounding while avoiding the ruinous temptation of market timing.
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