Have you ever tried to time the stock market? How did it work out? Did you rake in armfuls of cash or did you kick yourself for even making the attempt?
Chances are if you’ve been investing for any significant period of time, you’ve tried to time the market at least once. There is no denying the appeal of market timing. The prospect of buying a stock at its lowest point and selling it at its highest is thrilling (the image of me on a superyacht with a helipad just popped into my head). But, like all things that seem too good to be true, there's a catch, and it’s a big one.
Timing the Market is Difficult
The stock market is a complex creature. It's influenced by numerous factors, many of which are unpredictable. Political events, economic reports, natural disasters, inflation, interest rates, and more, can all cause sudden shifts in market trends, and often not in the direction you would expect. Trying to predict these shifts is akin to predicting which direction a hummingbird will fly next; you might get it right sometimes, but you'll never be accurate all the time.
And yet, despite the inherent unpredictability of the market, many investors continue to attempt to time their trades. They are lured by the promise of high returns and the thrill of 'beating the market'. But more often than not, this strategy leads to disappointment.
Emotion Fueled Decisions
Despite the obvious difficulties in predicting market direction, we as investors face an even greater foe, and that is our emotions, namely fear and greed.
The prospect of making quick profits can be incredibly enticing, leading investors to take on more risk than they would otherwise, and always chasing the hottest stocks or sectors; often buying near the top.
Conversely, the fear of losing money can cause investors to sell their stocks at the first sign of a downturn, often at a loss, because they are certain it’s going to keep dropping. Or, worse yet, they hold onto a losing stock in hopes that it will recover, often selling near the bottom because they just want the pain to stop.
The constant battle between fear and greed in the mind of an investor creates a relentless flow of seesaw decisions that lead to buying high and selling low, the polar opposite of the intended plan. These emotion-fueled decisions can quickly erode portfolio balances and sabotage long-term investment goals.
It has been well-documented by researchers that our investment decisions are often guided by our emotions and not logic. We’ve all read about the dangers of timing the market, and we set out with good intentions, but when the market starts to drop, logic heads for the exit and our emotions are now in control. If markets continue to drop, panic takes over and our fight or flight instinct tells us it’s time to hit the sell button, even though that was never part of the original plan.
How Damaging is This Behavior?
If there is one thing the financial industry loves, it’s statistics, so I’ll share some with you that highlight the dangers of trying to time the market. The data shows that the more often you try to time the market, the worse you’ll do.
A Morningstar 2023 report showed that for the 10-year period ending December 31, 2022, the average investor experienced a return that was 1.7% per year lower than the actual return of the funds they used. The diminished performance was the result of trying to time entries and exits in those funds. Had they simply remained invested, they would have boosted their returns by 1.7% per year.
A similar report by DALBAR showed that over the 20-year period from 2000 to 2019, the average equity investor lagged the S&P 500 by 2.08% per year. By attempting to time the market, investors significantly lagged the index.
A study by Barber and Odean (2001) found that the most active traders fared the worst, with active traders lagging the S&P 500 Index by 6.5% annually.
Research by J.P. Morgan Asset Management revealed the impact of missing the best-performing days in the market. From 1999 to 2018, an investor who remained fully invested in the S&P 500 would have earned an average annual return of 5.62%. However, missing just the ten best days during that period would have reduced the average annual return to just 2.01%.
Following the last point, in a joint study between Ned Davis Research, Morningstar, and Hartford Funds, they found that 78% of the best single-day returns for the stock market came during bear markets or the first two months of a new bull market (when many are reluctant to jump back in the market). For investors who missed only the ten best days over the past 30 years, their portfolio balance was less than half that of an investor who remained fully invested during that same period.
What’s the takeaway? I’ll let you decide.
How Do We Overcome This?
Recognize the behavior. Understanding these psychological tendencies is crucial for any investor. By recognizing how your emotions can influence your investment decisions, you can take steps to mitigate their impact and make more rational, informed choices. The next time the stock market starts to misbehave, resist the temptation to time your exits and entries. Remind yourself of the statistics above, and realize that by trying to sidestep a potential bear market, you will most likely realize a lower total return over your lifetime.
Diversification is a key strategy for reducing portfolio volatility (large fluctuations in value). By spreading your investments across various asset classes, sectors, and geographical regions, you can reduce exposure to any one area and increase your chances of achieving a smoother, more consistent return. A more consistent return is often more palatable to a long-term investor and reduces the likelihood of making a rash decision during a market downturn. This diversified portfolio should be based on your investment goals, risk tolerance, and time horizon, and rebalanced periodically to help keep your portfolio aligned with your target allocation.
Ignore the noise. The financial media does not care if you reach your financial goals. They care about selling ad space, and they do that by keeping you glued to their channel/page with stories of recession, the next hot sector, or the next CPI report, all of which will send you into a tizzy trying to predict the next move you should make. Ignore them.
Consider working with a financial advisor. There have been many studies (by Morningstar, Vanguard, and others) that attempt to quantify the value an advisor adds to a client’s financial situation. The value added comes in the form of appropriate asset allocation, tax-efficient investments, and tax-loss harvesting, to name just a few. However, the studies show that helping clients stay invested during market turmoil is often where the most value is added. An advisor can not only help you apply a consistent and disciplined approach to long-term investing, but can also be the voice of reason, the sounding board, and even the firewall between you and a costly decision.
Conclusion
While timing the stock market may seem irresistible at times, it's fraught with risks and challenges. The unpredictability of the market, the rollercoaster of emotions, and the potential for missed opportunities and diminished returns, all make market timing a risky proposition.
Instead, the data shows you should take a long-term approach to investing. Develop a diversified portfolio that’s aligned with your goals, your appetite or need for risk, and your investment time horizon. Rebalance periodically and hold onto your portfolio through thick and thin, only making changes when circumstances in your life change and a change is truly warranted.
By focusing on the long term, you can ride out short-term market fluctuations and take advantage of the compounding effect of returns, which is a much more reliable and less stressful way to grow your wealth. And if you need help, consider working with a financial advisor who can help you develop an investment strategy and stay the course.
To drive the point home, I’ll leave you with a quote from Warren Buffett speaking about the investment philosophy employed at Berkshire Hathaway, “Our favorite holding period is forever.”
Tad Jakes, CFP®, EA