Market timing is the practice of moving money in and out of the market, or in and out of specific sectors of the market, based on a belief that the market, or specific sectors of the market, will do well (in which case you’d be in) or poorly (in which case you’d pull out) in the future. If you’ve read about stock picking, market timing might sound familiar. Market timing is similar because it’s also built on a false premise that the market is inefficient, but it’s also a little bit different. Market timing is more subtle than stock picking. Instead of a belief that you can buy underpriced stocks and sell overpriced stocks, market timing is a larger bet on the future of entire market sectors. It gives the allusion that you can simultaneously be well-diversified and engage in market timing since you might always own a few different asset classes. It’s sort of like stock picking in disguise (it’s often called ‘tactical asset allocation’ which sounds super smart) because it’s essentially picking market sectors (asset classes) instead of stocks. Market timing can seem more legitimate than stock picking, but it’s still essentially gambling.
Market timing is unfortunately just as pervasive in the investing world as stock picking. It is often incited by panic, people move their money around or out when the market seems especially scary and move it back again (or not) when the market feels more safe. The timing tends to be exactly opposite of what should be done, people end up selling low and buying high and sacrificing millions of dollars in returns. But damage is done apart from panic too. Dalbar (an investor research company) reports that the average equity (stock) fund investor stays invested in their funds for only 4 years before jumping to a different set of funds, perhaps unintentionally market timing. Money managers routinely shift strategies within popular mutual funds (referred to style drift), shifting focus between market sectors. Pundits constantly discuss market trends which include market timing suggestions. Similar to stock picking, we’re so immune to market timing that it just sounds like normal investing at this point. That’s bad, here are a few reasons why:
1) People are bad at market timing. A study by William Sharpe conducted in 1975 (Likely Gains from Market Timing) concluded that in order for a market timer to beat a passive fund they would have to guess right about 74% of the time. An update to the study by SEI Corporation in 1992 concluded that the market timer would have to guess right at least 69% of the time, and sometimes as high as 91% of the time in order to beat a similarly invested passive fund. So the important question is: does anyone guess right with that frequency? Maybe you’ve made your own guess by this point, the answer is a resounding no. CXO Advisory did a fascinating study on the success ratios of market timers between 2005 and 2012. They looked at 68 ‘experts’ who made a total of 6,582 predictions during that period. The average accuracy of all predictions? 46.9%, well short of the minimum 69% threshold. These predictions sell news subscriptions and online adds, but they’re detrimental to investor returns.
2) Market timers miss out on returns. Trends are a big topic in the world of investing. Market timers analyze previous trends, they track current trends, and they look for the next trend, it’s incessant. Nejat Seyhun in a 1994 study entitled “Stock Market Extremes and Portfolio Performance” analyzed the period between 1963 and 1993 (a total of 7,802 trading days) and found that only 90 of the days were responsible for 95% of the positive returns. That’s about 3 days per year on average where 95% of returns came from. In all the misguided ‘trends’ talk and the popular practice of moving money in and out and all around, market timers routinely miss the most rewarding days in the market. Instead of focusing on market trends, investors would do much better to focus on the whole market and ride the general stint of the market upwards.
3) Market timers misunderstand the market. The most culpable cause of market timing is panic. People do crazy things when they’re scared and their money is on the line. Don’t get me wrong, the stock market can seem pretty scary, and it definitely involves money, but just because it seems scary doesn’t mean you should be scared. The average market crash of 10% or more lasts just under 8 months, 4 months until it hits the bottom, and just under 4 months to return to the pre-crash high. That’s not so scary. Over the last 93 years (going back as far as we have super-reliable data) 68 years were positive by an average of 21%, 25 years were negative by an average of 13%. Also not so scary. There are 45 countries in the world with free markets and the ability to buy and sell stocks and over 17,000 companies to invest in. What would it take for a well diversified portfolio to lose everything? Only some type of global apocalyptical event, at which point you probably wouldn’t be concerned with the amount of money in your portfolio. That is scary but not because of the market, it’s actually pretty reassuring as far as your portfolio is concerned. Instead of panicking, investors would do much better to rebalance during turbulent markets and capture returns on the way back up.
So market timing is a losing game. It can’t provide any consistent value to a portfolio, it actually causes a drag on returns, and it’s often driven by an inaccurate understanding of the market. Unfortunately it’s prevalent, and many portfolios engage in market timing while investors remain unaware. So take a look, have an advisor do an analysis for you. It pays to understand how you’re invested and to avoid market timing in your portfolio.
Sources:
Joshua VanDyke Advisor 