We have completed our 199th podcast — leading us into today’s article —at Financially Simple, and I am so thankful to have been able to share my financial expertise with each of you over that time. However, those of you who have followed the entire series — or at least most of it — have likely noticed that I have avoided the 800-pound gorilla in the room. I’m talking about investing. More specifically — for this article — I’m talking about the strategy of investment market timing. I’m sure you’ve heard about it before but is it really the best way to buy and sell your equities?
Follow Along With The Financially Simple Podcast!
Podcast Time Index For: “What Is Timing the Market and Does It Work?”
The simple answer to this question is yes. When you invest, you are putting your money to work and harnessing the power of compound interest. I’ve said this before but the fact remains the same, your dollar will never be as valuable as it is today. Simply hoarding your money in a cash position is the least efficient way to build wealth. Now you might be thinking, “Justin, if I am socking my money away and never spending it, I’m building a fortune.”
RELATED CONTENT: Investment Basics – Part II: Risk Tolerance and Investment Horizons
To a small extent, you’d be correct. However, cash is susceptible to inflation. When you are hit by inflation, you’re going to feel it all the more if you’ve never allowed your savings to benefit from compound interest. So if you have the means to invest and allow your money to work for you, by all means, take advantage of the opportunity.
Investment market timing is the strategy of making buying or selling decisions of financial assets by attempting to predict future market price movements, according to the interwebs. Search results on the subject continued, saying, the prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis.
So what does that mean, exactly? If you are going to invest your hard-earned money, it seems like the best possible strategy would be to simply sidestep all of the potential marketplace losses (as the chart aside illustrates), right? That’s the basic idea behind timing the market.
Let me first point out that the strategy can be applied to any manner of investment. For our purposes, today, we will stick with stocks but the strategy is used in real estate and business as well. Coming back to the root question of whether or not it works, a recent study by Dambar, of the 2008 market crash, showed that the average investor’s stock funds lagged behind the S&P 500 (a popular index but not the end all be all..IMO) by 4.66% per year over the previous twenty years. Part of this is due to poor timing decisions, according to DALBAR’s analysis.
The study reported that “in thirty years of market investor returns, DALBAR found that equity investors underperformed the S&P 500 to the greatest extent in October 2008. In this month, equity investors lost 24.21% compared to an S&P 500 loss of 16.8%. The net underperformance was 7.41 percentage points.”
The next greatest underperformance occurred in March of 2000. This was the time of the tech-bubble era which caused the S&P to surge to 9.78%. However, investors only saw returns of 3.72% for an underperformance of 6.06%. What this shows is that the underperformances result from bad investor decisions at critical points. First, in the S&P 500 surge of 2000. Then in the crash of 2008.
DALBAR recently stated, in a report from March of 2019, that “the nation’s leading investment behavior study over the past 25 years found that the average investor took some money off the table in 2018 but was still poorly positioned for the second half of the year. The average investor was a net withdrawer of funds in 2018 but poor timing caused a loss of 9.42% on the year compared to an S&P 500 index that retreated only 4.38%.”
This wasn’t merely an anomaly that occurred during market downturns. The same report went on to state that the average investor underperformed the S&P 500 by more than 100 basis points in two different months. October — which was a bad month — saw the average investor lagging by 113 basis points, while in August — a strong month — that number actually increased to 146 basis points. The problem, according to DALBAR, is compounded by being out of the market during the recovery months.
The trends shown in the DALBAR reports are not uncommon in attempts to time the market. In fact, an excellent research paper from the Brandes Institute stated that the average gain during the first three months after a market downturn was 21.4%. A market downturn is a drop of 20% or more. Yet I believe most market timers tend to be concentrated in cash during the first three months just after a crash, so market timers typically have missed most of the recovery’s upside.
In order for market timers to achieve investment success, they would need to forecast:
Do you think you’re up for the challenge? I know I’m not. However, if that doesn’t quite put things into perspective, consider this, Just 81 trading days, out of 13,844 trading days would have equaled the total return for the buy and hold investor over a 55 year period, thus resulting that if one of these 81 days were missed over this 55 year period, the annualized return would fall from 9.87% -.03% return.
If you think that timing the market looks impossible from the perspective of the average investor, it doesn’t look any better for the professionals either. The Journal of Financial Economics, in an exhaustive study of 237 market timing newsletters published between 1980 and 1992, found that less than 25% of the recommendations made within them were correct. So why do we even try to time the market?
In a word? Overconfidence. We think that we can be fast enough, smart enough, and just clever enough to reap all of the rewards and completely avert disaster. The truth is, none of us can definitively say what the market is going to do. It zigs when we think it’s going to zag, dips when we think it will soar, and shatters the ceiling when we think it’s about to plummet.
Would be timers often make decisions because of a number of biases, and there is a big psychological problem that underpins many of these biases. The word is apophenia. It is a tendency to mistakenly perceive connections and meaning between unrelated things. While conspiracy theorists are the most well-known apophenia sufferers, plenty of investors fall into the same trap.
In truth, the average investor doesn’t stay invested for a long enough period of time to fully reap the rewards of their investment. It is far more important to make sure you’re invested during a bull market than it is to avoid a bear market. Historically, bull markets outperform nearly five times in average gains versus average losses in a bear market.
Life is hard enough as it is, people. It’s crazy, it’s complicated and difficult, but at least money doesn’t have to be. With the right information, investing can at least be financially simple.
Get more of our Investing segment articles in the Personal Finance for the Business Owner series by following along.