What is market timing?
Market timing is an investing strategy where investors move in and out of the market to try and avoid losses before they happen and buy-in at the bottom after the market has crashed.
Someone who is trying to time the market would sell their position in the stock market if they believed the market was about to crash. They would wait for that crash to happen and buy stocks while they are “cheap”. It’s the ultimate embodiment of “buy low sell high”. Market Timing makes for a great story. However, like all forms of active management, the strategy of market timing falls apart under scrutiny
Why market timing is appealing
We’ve all heard the age-old adage “time in the market is more important than timing the market.” This is advice that on an intellectual level nearly everyone acknowledges is true.
The rational investor knows there will be short term volatility in the market. What happens in the short term should be inconsequential if you’re investing for the long term. Most investors are probably nodding their heads in agreement with that statement. But very few investors have the discipline to stick with their investment strategy when the market gets volatile.
Market timing doesn’t work… but everybody wants to find out for themselves
As humans, we suffer from many cognitive biases one of which is “loss aversion”. We experience a more intense emotional reaction from losing than we do from winning. Put simply, we hate to lose more than we love to win. The idea of watching our hard-earned money evaporate before our eyes during a market crash is terrifying.
Humans also suffer from “overconfidence”. The rational part of our brain tells us that market timing doesn’t work. Meanwhile, the irrational part of our brain tells us that we are the exception to that rule. “Market timing doesn’t work for most people, but they don’t know what I know”.
Combine loss aversion with overconfidence and you can see why people buy into the fairy tale of market timing. It’s nice to believe that you can invest in the stock market without having years where your investments go down.
The reason the stock market has such high expected returns is that it involves risk. The higher returns are the reward for taking on risk. This is referred to as the risk premium and explains why stocks have a better return than government bonds.
The idea of market timing implies you can have the high returns of investing in stocks without taking on the risk. If it sounds too good to be true, it’s because it is.
A lesson from Issac Newton
Market timing strategies are implemented when stock prices are high. When people read headlines about the stock market hitting a record they get nervous. Afterall “What comes up, must come down”. It is true that when stock prices are high we expect lower future returns. However, lower returns don’t guarantee negative returns.
There is research that suggests that when stocks have been increasing in price, they continue increasing in price for some time. This is referred to as momentum. As Issac Newton put it “An object in motion tends to remain in motion”.
The risk of market timing
When an investor pulls their money out of the market they run the risk of missing out on gains if the stock market surges upwards.
Merril Lynch recently researched this very subject. They examined the return on a $1,000 investment in the S&P 500 from 1989–2018 under three scenarios.
- Scenario 1: The investor implements a buy and holds strategy.
- Scenario 2: The investor pulls their money out of the market and misses the 10 best performing months.
- Scenario 3: The investor pulls their money out of the market and misses the 20 best performing months.
The results demonstrate the risk of market timing.
- The buy and hold investor ended with $17,306, a 1,631% return on investment.
- The investor who missed the 10 best performing months ended with $6,959, a 596% return on investment.
- The investor who missed the 20 best performing months ended with $3,328, a 233 % return on investment.
Don’t listen to your gut
The lure of market timing will be strong in periods where the stock market is setting record highs. Your gut will tell you that the next big crash is right around the corner. As difficult as it is, you should ignore that feeling and stick to your current investment strategy.
The next big market crash could be around the corner. Or it might not come for 20 years. You have no way of knowing which possibility will come to pass and by pulling your money out of the market, you expose yourself to the risk of missing out on some of the market’s best months of returns.
Successful market timing requires you to know two things.
- Exactly when to pull your money out of the market.
- Exactly when to put your money back into the market.
Odds are that you would sell too early and buy back in too late. In the process, you would lose all the benefits of market timing and expose yourself to the risk of missing the market’s biggest gains.
Bringing it all together
Investing involves risk. Trying to avoid this risk by timing the market simply opens you up to more risk. Anyone who invests in the stock market needs to accept the fact that they will have years where their investments are down.
If you can’t accept that you are not cut out to be a DIY investor. There is no shame in that. It simply means you should hire a professional to help you manage your investments and avoid the temptation of trying to time the market.
Have you ever attempted to time the market? If so, what was your thought process behind that decision? Let me know in the comments.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions