The Fairy Tale of Market Timing
In the rich land of investing, it’s difficult to discern between what’s real and what’s fantasy. Hundreds of finance books claim to have the secret to becoming a millionaire. They sound too good to be true, and they undoubtedly are. After all, why are there so many of these books if one method actually works? What they’re really selling are just fairy tales.
Investors are better off reading the classic fairy tales. They provide value in simple but important lessons for the real world. For example, consider what the stories about the boy who cried wolf and Goldilocks can teach when debating the right time to enter the market. The media is filled with dubious cries of market predictions, from future corrections to stagnant returns. Investors are told to either buy or sell, that the market is either too hot or too cold, or that it’s better to wait until the market is “just right” to invest.
Hearing those calls leads many investors to time the market by waiting for what they perceive to be better conditions or by gradually putting in money over a period of months. But, market timing is like trying to have your porridge and eat it too. The reality is that the market is a zero-sum game—if one investor buys at the right time, then another investor must have sold at the wrong time, and vice versa. Unfortunately, most investors that try to find a right time to enter the market soon find themselves trading at the wrong time.
Accurate market intuition is make-believe
The inability of humans to predict the future makes it nearly impossible to accurately determine the right time to enter the market for the best returns. Doing so only happens out of pure luck. While some financial advisers will have you believe otherwise, investors can only speculate about market changes and they have a bad track record of being right.
Consider investor sentiment during the Great Recession in 2009. Only 18% of investors surveyed in a Gallup Poll conducted on March 4, 2009, felt that the stock market would show sustainable growth by the end of the year. The rest thought it would take two or more years to recover, with 2% even thinking it would never recover. From March 9 to the end of the year, the S&P 500 gained 67%.
Source: Gallup Poll
Such inadequacy is also on full display in a 2013 study by Boston research firm DALBAR. In a 20-year period, investors in U.S. stock mutual funds earned average annualized returns of 4.25% compared to the 8.21% return generated by the S&P 500. Part of the reason for the large disparity, in addition to fees and expenses, is the decisions made by the investors themselves—meaning, investors typically get in and out of markets at the wrong time.
Those decisions are likely influenced by so-called experts crying “wolf.” Following the advice of talking heads in the media is an unwise decision in itself. In a 2010 academic study titled, “Behavioral Portfolio Analysis of Individual Investors,” researchers Arvid Hoffmann, Hersh Shefrin and Joost Pennings found that a segment of investors who made investment decisions based on “financial news, intuition and professional advice” showed some of the worst performance, producing a monthly net return of -0.71%.
The very real loss of returns and income
A true story in finance is the effect of the market’s best and worst days on your returns. Unfortunately, neither can be accurately predicted. A Vanguard study of the S&P 500 found that eight of the market’s best 20 days happened within 10 days of the 20 worst days. Therefore, market swings can be deceiving, but what’s clear is that being on the sidelines means missing some of the market’s best gains, which also can make up a large portion of long-term returns.
Of course, entering the market comes with the risk of potential losses, but there are also potential losses by largely holding cash. For instance, cash accounts generally produce a return near zero net inflation, so there’s the loss of return potential. In addition, there’s a loss of income, as cash does not produce the additional income generated by equity dividends and bond interest.
The powers of a portfolio
Trying to rely on an ability to foresee the perfect moment to enter the market causes investors to overlook the special powers of a portfolio. Namely, a portfolio has the potential to create a positive overall return out of a mix of different assets. Even as one asset declines during a market drop, the portfolio as a whole can still do well.
Thus, a better method than searching for a magical entry point into the market is jumping right in with a well-balanced portfolio of assets that meets an investor’s financial needs at a comfortable level of risk. Then, consistently rebalance to stay on track during both good times and bad times. It should be believable that this offers a higher probability of success in the market than simply guessing.
And this way, an investor doesn’t have to listen to the made-up stories of boys and girls about things that may or may not become real.