Are you considered clairvoyant? Do you win an office football pool every year? Can you accurately and consistently predict 10 coin flips in a row? Are you a palm reader? Are you the sort of person who, while possessing no psychic abilities, does not mind spending hours crunching numbers and analyzing obscure data in hopes of discerning future trends?
If you failed to answer yes to any of these questions, then market timing may not be for you. The belief that you, or any particularly person, can foresee the direction of the stock market is a seductive one. Some investors are confident that, with proper research, they can make money by snapping up equities when prices are low, and shifting their investments into cash or bonds when the market hits its peak. But longitudinal studies have shown that most market timers not only fail to beat the market, they may actually earn less over time than buy-and hold investors.
However, many armchair investors persist in the belief that, by carefully following business news and trusting their “gut” instincts, they will be able to out-smart the market. Some study the stock tips in personal finance magazines, others hope to glean additional insight from analysts’ reports and specialized investment newsletters, and still others attempt to mine all the available data, crafting complex simulations of how the market is likely to behave in the future.
But if financial professionals who do this for a living struggle to accurately predict where the stock or bond market might go, private investors are even less likely to outfox the markets. As soon as a piece of business or economic news hits the airwaves and the Internet, analysts and brokers react immediately to the information (this is call "The Efficient Market Theory" in finance). Because of financial professionals acting quickly, the market mechanics create a situation where the stock market almost always reflects all the known information at any given moment in time. And even if an individual investor were able to develop an analytic model with some real predictive value, unexpected events—such as a terrorist attack, a natural disaster, or even a political scandal—typically leads to sudden and dramatic market fluctuations that no model based on historical data could have anticipated.
It is only natural that investors would want to find some way to sit out bear markets and get back just in time for the next bull run. It is useful to keep in mind, however, that even the slowest equity markets have some bright spots. A well-diversified portfolio will help you protect against loss and capture whatever gains might occur in a market downturn.
Investors run a big risk by selling when they believe stocks have reached their peak. They may turn a profit when cashing in their equity holdings, but they could also miss out on some of the market’s best cycles. Being absent from the market for only a few of the days or weeks with the highest percentage gains can decimate a portfolio’s returns over time. Market timers who sell frequently also lose money to transaction costs and taxes, and miss out to a large extent on the compounding effect that benefits investors who remain in the market consistently. The vast majority of investors are better off, instead of trying to time the market, just being in the market. Of course, investors need to be in the right investments that match their risk tolerance and time horizon.
Trying to pinpoint the right time to invest in the stock market is an exercise in futility. If you have a longer period to save, owning equities provides the most effective hedge against inflation and taxation available. Since it is impossible to know where the market might go from here, remember, that long-term investment success is achieved not by timing the market, but by time in the market.
-Paul R. Rossi, CFA
Paul R. Rossi, CFA