Timing Markets

As Nancy Reagan taught my generation, “Just say no.”  She was talking about illicit drugs, and I am talking about market timing, but the advice is the same.  The sad, simple fact is that the average stock market investor fails to match the average, let alone beat it.  This lack of success often has to do with attempts at market timing.  Conventional wisdom tells us that there are good times to be in the market, and there are good times to be out of the market.  If you simply buy at the bottom (get into the market) and sell at the top (get out of the market), you can make a fortune and beat the average return of boring indices like the S&P 500.

The problem with this strategy is that there is no consistent way to determine where the bottom is and where the top is.  The most common result is to be out of the market when the biggest gains are to be had.  Markets move quickly, and you have to be glued to a trade screen to even attempt market timing.  Simply put, market timing does not work.  You will get out just as the bottom is reached, and miss the quick recovery.  The permutations are many, but the result is nearly always a loss.

If we could magically produce a graph of the path your savings were likely to take over the entire time from when you start investing until the point that you are ready to retire, you would never dream of “getting out” of the market.  The problem is a psychological one, and it has to do with your own psychology.  The daily ups and downs can be scary if you don’t have a firm understanding of long-term trends and the discipline to just stand there when things seem to be melting down around you.  You also have to ignore a host of antagonists that will try to convince you that you should indeed time the market.  You will often hear that the sky is falling and that you must take quick action or else you be “crushed” or some other colorful verb that connotes death and destruction.

It is a generally accepted principle among economists that markets are efficient.  The formal statement of this position is usually attributed to Nobel Prize-winning economist Eugene Fama and is known as the efficient market hypothesis (EMH).  His version was much more elaborate, but the basic idea is that since everyone has access to news about companies at the same time (because of modern Federal laws if nothing else), information about the value of a share is incorporated into stock prices nearly instantaneously.

The appearance of patterns of stock price movements that seem to be able to beat the market can always be explained by the fact that investors are taking on more risk.  In other words, Wall Street only rewards investors for taking on risk and nothing else.  Fama’s view of the markets as perfectly efficient is something that I disagree with, but I will agree that markets are efficient enough to crush market timers.

To make matters worse, beating the market is not a coin toss bet as many investors assume.  In a 1975 research report, William Sharpe demonstrated that the investor must call the direction of a move correctly 69% of the time to 91% of the time, depending on the strength of the move.  You may be lucky, but you are not that lucky.  Never forget that active traders, many of whom are supercomputers, drive daily fluctuations in price.  The research evidence is convincing:  Passive investing strategies beat market-timing strategies around 80% of the time, which means that active investors will win about as often as you would expect them to win choosing stocks by throwing darts and the Wall Street Journal.

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