This year has been a roller coaster for investors. As a result, it provides a great case study on market timing (more specifically, why timing the market doesn’t work and should be avoided).
I realize we have a lot of aspiring and beginner-level investors here, so for those not aware of what market timing is, Wikipedia aptly defines market timing as:
“The strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.”
Kind of alluring, isn’t it? So let’s take a walk through this year’s market timing lessons together to make it not so alluring…
The Allure of Market Timing
The stock market started out pretty calm this year, building on a long ascent over time, as markets entered their 7th year of an aging bull market. When bull markets are this long in the tooth, it’s almost like investors are just waiting for bad news to happen to tear it all down. And they got what they wished for with a series of unforeseen events…
Russia/Ukraine happened. And Greece. And more Middle East unrest. And the Shanghai Composite index (Chinese stock market) collapse. And fears over the Fed raising interest rates in the United States as the economy picked up steam.
All of this market tension and volatility built into the perfect storm until finally, investors flipped the F out. And this happened…
Forget roller coaster, that’s more like the Demon Drop (Cedar Point reference… anyone?).
Within a matter of 2 days, the Dow index had dropped from 17,500 to 15,500 (-12%). And it was 16% off from a high of 18,400 earlier in the year. The drop was dubbed the “Flash Crash”, and it resulted in the following exchange with a colleague:
colleague: “Hey, I saw that I lost $3,000 in my 401K the other day. I thought those returns were guaranteed with the 401K match.”
me: “No. 401K matching does not guarantee market returns. Investing returns are never guaranteed.” (I wisely substituted this for: “Is that it? Consider yourself damn lucky, YOU PUNK!”)
colleague: “Bummer. I am freaking out.”
me: “Don’t panic. You’re young, what happens today won’t matter 50 years from now. Besides, you’re probably still better off than from where you started, right?”
My colleague wasn’t alone. Deep down inside, I was freaking out a bit myself, as were most investors. Earlier in the year, I had moved almost all of my assets into stock investments. My colleague was concerned about $3,000 in losses, but in just those two days, I had lost more money than I have made in annual earnings in many of my post-grad years of employment. That’s some scary stuff. The thought of a 30-40% drop as we had in 2008? Absolutely frightening. And yes, the thought did enter my mind. At this moment of panic, your emotions are screaming at you to “Sell! Sell! Sell!” in order to avoid further losses. Then, get back and enjoy the ride back up when the chaos has subsided. That’s the allure of market timing. But, it’s a trap. The reality of this case study is that you would have locked in 12% losses.
Every Prognosticator is Right… Eventually
Every doomsday market prognosticator just knew a market correction was going to happen. And they were finally right. Of course, there were some important details they didn’t accurately predict:
- When the market correction was going to happen – both in market value and in timing (many had been predicting it each of the last 5 years and when the Dow hit 10,000, 12,000, 15,000, and 18,000).
- What was going to cause it (interest rates were the speculation, but nobody knew the exact cocktail of crises that would send investors into a panic).
- How long before it recovered its losses.
Why Market Timing Doesn’t Work
Predicting when the market would rebound was just as unlikely as predicting when it would drop. The market (shockingly) recovered more than 50% of its losses in just 2 days. Today, just 3 months later, it has recouped 100% of its losses, and is actually in positive territory for the year. The Greece and Chinese panic seems to have at least temporarily subsided. And market reaction to interest rate hikes has gone from a downward fear to an upward positive (I still can’t figure that one out).
The biggest lesson here is as I highlighted back in my lessons from the flash crash post while this was all going down:
“You. Just. Can’t. Time. The. F’ing. Market.”
Timing the market, in theory, could work. But you’d have to accurately predict a lot of unpredictable things – which makes succeeding at it pure luck – a game of chance (no different than rolling the dice really). Anyone who says they accurately predicted exactly when the correction was going to happen, at what level, and how quickly it would turn around is blowing smoke up your nether regions (go ahead, try to find one person who accurately predicted all of this, I challenge you).
Here is why market timing doesn’t work:
- Investors behave irrationally, and therefore, the market can be priced irrationally.
- You cannot accurately predict when the market will go up and when it will decline. Or, by how much.
- When you have the strongest emotional urges to buy and sell are often precisely when you should do the opposite.
- You never know what unexpected events are going to happen that could immediately flip market trending.
- You aren’t smarter than the market.
Expanding on that last point, we like to think that we are smarter than everyone else at valuing the market. We are not. Even professionals with sophisticated algorithms and valuing software and years of professional expertise typically under-perform the market as a whole. Passive investing beats active investing for many of the same reasons why you can’t accurately time the market. Nobody really knows when it is going to go up, when it is going to go down, and by how much. The same is just as true for individual stocks as it is for the market as a whole.
Plain and simple, market timing does not work. So don’t do it!
A Better Investment Strategy than Market Timing
Instead of trying to time the market, the investment strategy that is mostly likely to succeed for you is to:
- Passively invest in low-cost ETF’s and index funds.
- Consistently add to your investment positions over time and re-balance periodically.
- Do not panic sell. Buy when others are selling.
It takes a little patience and discipline, but wealth will come to those who can muster it.
Luckily I’ve learned a few things from Buffet and when the market dropped the, I put in an order for more. It has turned out pretty well for me.
The funny thing about that period was that the Fed was mulling an interest rate raise (horror, pandemonium, and the like) and decided against it, and the talking heads decided that the Fed didn’t have faith in the economy, so that caused the horror and pandemonium. Sometimes I think that they will do anything to get a good deal.
Betterment has an interesting tool that helps illustrate market timing is borderline impossible. It gives you an actual historical headline from the NYT and you have to guess whether staying in cash (e.g. assuming the market will go down) or investing in stocks would have been a good idea based on how the market fared the next six months:
Granted, if you’re an active market timer you have more than just one newspaper headline to guide you, and you probably won’t stand pat for six months after each decision. Still, it shows the point fairly well. If you want something more in-depth there are a lot of thorough articles, including some on this blog, that prove almost nobody is able to successfully time the market on a consistent basis.
Readers can check out my Betterment review for more info. on Betterment (an investment brokerage that favors passive investing).
woo cedar point!
Thanks for such an interesting article. Quite a timely one as well since I am interested in investing in ETFs next year. Any pointers?
This is great advice for all investors, especially those who are just starting to invest. I appreciate that you took the time to provide a nice graph and data to support your key points. I also liked that you ended with a specific action plan that is easy to understand. Thanks and keep up the good work!
We’re about to have another correction where articles like this will hopefully be good reminders of what not to do. Get your allocation properly set and also make sure it’s not boilerplate like so many out there. My Portfolio Guide also recommends building a strong portion of your allocation using alternative investments to not only diversify but help hedge downside risk.