The Pitfalls of Market Timing

 

If you’re a long time follower of mine (I’ve now been writing and speaking on the topic of investing for almost 14 years, and now on Twitter) you know if there’s one thing I’ve warned against the most frequently, it’s market timing.  Market timing is the act of wholesale moves into and out of risk assets—stocks being the most obvious example—in the hopes of improving performance.

Simply put, market timing is the single biggest wealth destructor in history.

More money is lost on this fool’s errand than is lost to the other sinkholes of investing: egregious sales fees (think: variable annuities), commissions, fund “loads,” financial scams, and bad stock tips.

Remember the DALBAR statistic?  I do.  It’s a known fact that stock market investors do substantially worse than the stock market.  Why?  They buy high, sell low.  As a group.

Emotionally, investors greedily chase performance on the upside—accumulating risk when they should be offloading it—and then do the opposite in the face of falling prices.  Nevertheless, I haven’t given up hope that investors can learn to avoid timing mistakes.

Here’s the real shame of timing given that it hurts people—no one ever needs to do it.  If you have a diversified investment portfolio (and I define diversification more widely than most), you don’t ever need to time.  Everyone should have at least eight asset classes.  I use more like ten.  Assets that all investors should consider include:

  • US stocks
  • Foreign stocks
  • US bonds
  • Foreign bonds
  • Commodities
  • Real Estate/REITs
  • Foreign Currency
  • Other Assets (too many examples to name)

Multi-asset-class investing smooths returns over the long-run and reduces the impact of the worst assets in any given period.  The key volatility-dampening, drawdown-reducing  asset class is U.S. bonds.  The less risk you need to take, the more bonds you should own.*  So the best defense against a decline takes place before it happens, with the proper asset allocation.  If you own the right amount of bonds, you can endure the decline.  To know the right amount, you have to have a good financial plan…but that’s a topic for another day.

Let’s get back to timing.  People try to market time because they don’t want to see their assets decline any more in value after they’ve fallen.  It’s an understandable aim; but again, considering that all declines end in a fraction of the time most people are invested, declines don’t matter if you have the right allocation.

Classic market timing is when someone sells all their stocks and moves the proceeds to cash (the same can apply to any/all risk assets, like the ones mentioned above).  For timing to work, the investor needs buy back in at a lower point than where they left.  But since timers are fleeing in the face of what they perceive to be untenable risk, it’s a rare individual that finds a continued deterioration (price drop) to be inviting.  So most timers wait until the “all clear” signal is given—usually a consensus that market/economic conditions have improved.  The problem is that markets move way in advance of the news—they’re way higher by the time the “all clear” signal sounds.  Therein lies the rub.

Does timing work?  The earlier you get out, the better the chance that you’ll have an opportunity to buy lower (set aside the fact that of those that see a decline manifest after they’ve sold, few will buy in when they should).  So, ostensibly, if you wanted to increase the opportunities on the downside, you would have to be out early in a Bear market.  But the earlier you get out, the less chance that you’ll even see a big decline.

For example, history shows that if you sell when markets fall 5% from peak, 90% of the time you’d be wrong—no Bear market arises.  If you use a 10% decline as your target for selling, your odds go up to about 1-in-4 that you’d see an actual Bear market, but that’s still against you.

What if you wait until a Bear is confirmed (a 20% decline), and then got out?  That’s an apt question, considering that’s where we were Monday.

Well…let’s apply that rule to the 11 Bear Markets of the last 70 years and look at the subsequent market action:

A further decline between 0-10%: 6 occurrences (55% of the time)

A further decline between 11-20%: 2 occurrences (18% of the time)

A further decline of more than 20%: 3 occurrences (27% of the time)

If you had sold when the market entered Bear Territory, about half of the time the market would have recovered without falling much (>10%).  As a timer, you would have ended up chasing the market before you knew it and covering to limit your opportunity-cost damage.  One fourth of the time, you would have avoided real pain (the Bears of 1973-74, 2000-02, 2008-2009), and if you had mustered the courage to buy below where you exited, kudos.  The other two times, you might have had a chance to get back in at a reasonably lower level, if you could convince yourself to.

But the reality is that most people do their timing at the BOTTOM of the Bear Market.  It’s what forms the bottom.  Most folks exit in the bottom 5-10% band of the decline, only to watch the market explode to the upside.

Timers rarely cover a bet working against them quickly enough to limit damage, hoping for the market to reverse itself.  Hope is no strategy for investors.

Here’s the take away: if you’ve never timed, don’t do it.  If you do, I pray that you’re wrong—so you’ll only have to learn the lesson once.  The worst thing would be for you to do it get it right this time.  The numbers say you’ll get it wrong two or three more times before you learn.  Ouch.

What you really need to understand is that the market is smarter and trickier than its smartest and trickiest participant.  Nobody in the world can time the markets.  The folks that called the 1987 Crash or 2000 Tech Bubble went on to spectacular failures of omission in future Bears.  The day traders that tell you investing is foolish are not “timers”—they’re day trading, not market timing—if they thought they could do it, they would.  There are no successful hedge funds that are timers.  There are no Shorters that can time.  It’s a myth of investing.

So let it go.  If it hurts to count how much money you’ve “lost” since the peak, quit counting.  Own multiple assets, own the right amount of bonds, and wait for the recovery.  We’re in the last half of a Secular Bear Market for stocks and related risk assets.  It won’t be this bad forever.  The last thing you want to do is try to time the market and do real impairment to your assets.

* To a point. A portfolio with 100% bonds is riskier than one with 70% bonds.  Let us know if we can clarify.