Market timing makes investment decisions based on predictions of stock market movement, as opposed to buy-and-hold or dollar-cost-averaging investment strategies. Decisions to stop investing in a 529 college savings plan or change asset allocations during a stock market downturn are a form of market timing.
Although some investment professionals claim to have successfully engaged in market timing, most cannot do so consistently again and again. It is very difficult, if not impossible, to predict when the stock market will reach a bottom or a peak.
Failing to accurately predict a market bottom or peak will have a big impact on investment returns. Missing even a single day a year of the best stock market performance is enough to cut the 17-year return on investment for a 529 plan by more than a third.
Trying to time the market is not an effective strategy for most individual investors. You’d have to make correct predictions more than three quarters of the time to outperform an investor who remained continuously invested in the stock market.
Often, investment decisions are based on an emotional reaction to past stock market movements, not predictions of future movements. Investors tend to buy or sell after a major stock market shift, not before. Some investors chase after last year’s performance.
When stocks have appreciated in value, there will always be a temptation to wait a few more days before selling. When stock prices are dropping, emotions can trigger panic selling.
That’s a buy-high, sell-low strategy, not a buy-low, sell-high strategy.
Pulling out of investments when the stock market is low just locks in losses and makes you miss out on a subsequent stock market recovery.
As this chart shows, the stock market swings have become greater in magnitude since the start of the bear market on February 19, 2020, but the number of vibrations up and down did not change by much. There were 15 valence shifts in January and 16 in March.
The main difference is the stock market’s earthquake and aftershocks averaged more down than up through March 24, 2020, when the recovery began, and then shifted to have more of the performance above the x axis instead of below. So, even though the swings are bigger, what really matters is how much of the swings are above or below zero.
There are two main problems with trying to time the market. The first is the transaction costs may eat away at the improved return on investment. The other is that your strategy for timing the market really has to be close to perfect, and nobody is that good. In most cases, market timing will underperform as compared with someone who remains continuously invested.
Most big stock market movements are complete surprises. The average annual return on investment in the S&P 500 from 1980 to 2019 was 10.1%. If you missed the best day of each year, the average annual return on investment drops to 6.4%. If you use the average aggregate return on investment for all 17-year periods ending in 1980 through 2019, the figures are 260.8% and 120.8%, respectively. Thus, you will lose about two-fifths of the return if you miss the best day each year, as compared with someone who remains invested for the entire year.
The return on investment over a 17-year period depends heavily on just a few days for most of the aggregate performance. Missing the best five days of any 17-year period cuts the aggregate returns on investment at least in half.
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It is easier to predict the weather than to predict stock market movements. If you want to predict tomorrow’s weather, just look out the window today. But, momentum plays like this generally don’t work well when it comes to the stock market. The odds that tomorrow will head in the same direction as today, upwards or downwards, is about 50%. In other words, it is no better than a coin toss. The odds of a three-day streak are 25% and the odds of a four-day streak are 13%.
This chart shows that the performance of the best 3-day streak each year is not much better than the best single day. So, momentum plays are not going to improve returns by much even on the best of days.
Beware when someone tries to get you to buy or sell a particular investment at a particular point in time, especially if the investment is thinly traded. That’s not only a type of market timing, but also a sign of a possible scam.
- In a pump and dump scheme, the con artist gets other people to invest to drive up the price, then they sell before the price crashes when the demand drops.
- In a flim-flam scheme, the con artist will tell half the investors that a particular investment will increase in value, and half that the investment will decrease in value. After doing this for several investments in a row, each time slicing the set of investors cross-wise, some of the investors will be true believers because the con artist will have been “wrong” only a handful of time.
Hindsight is 20/20. It is easy to find evidence to support any theory after the fact. People selectively remember and promote their successes, not their failures. Even a stopped clock will tell the correct time twice a day.
Most mutual funds do not beat their benchmarks. So, why not invest in the benchmark directly using passive index funds and exchange-traded funds (ETFs)?