Market Timing: Great in Theory, Bad in Practice
Submitted by Reby Advisors | Certified Financial Planners | Danbury, CT on October 3rd, 2014
Sooner or later, you’ll encounter the following advice on how to make money on the stock market: Move into the market while prices are low, and then sell your investments after they grow in value. Few will tell you it’s easy—but many will try to sell you on this or that “system” so you can either invest for yourself and get rich, or write them a check so they can do it for you.
Marketing timing is a great theory. The main trouble with it is that it doesn’t work.
Numerous studies show that guru market timers are frequently inaccurate—even the traders who’ve been on a roll for a few years and people who have their own TV or radio shows.
Ever been to a casino and witnessed a table “getting hot?” Did it stay hot forever?
Even the brightest aren’t good enough at market timing to make it work
In a study conducted by Nobel Laureate William Sharpe, he sought to find out how often a timing expert has to be right to break even relative to a benchmark portfolio. The percentage he came up with is 74% of the time.
In an evaluation done on the top 34 time picking gurus’ accuracy on forecasts ranging from 2000 to 2012, the highest grade anyone scored was just 66.4%.
Why is the market impossible to predict?
The stock market continuously sets prices based on the supply and demand for stocks. Supply is generally fixed in the short-term, but the demand for each stock is fickle. The news, the momentum caused by the news, and the emotional reactions of millions of investors to these momentum shifts, all factor into the rising or falling demand for stocks at any given moment.
In addition, there’s also pure speculation. Market timers aren’t speculating on stocks as much as they are speculating about other investors’ speculations. It’s not hard to see why no one has developed a scientific formula for predicting these movements.
There’s no room for error; miss the days with the biggest gains, and it’s hard to recover
According to a report by Oppenheimer, investors who missed out on the 10 best days in the stock market between 1980 and 2010 saw their earnings fall to 5.7% from 8.2%. Moreover, a Vanguard study found that stocks rise roughly two thirds of the time. Both of these studies show why market timing strategies dramatically increase your probability of missing out on gains.
Ultimately, it’s not how well you time the market. It’s your time in the market that counts: people who held onto their stocks through the bear market of the recent financial crisis have more than fully recovered—and even profited since then. Many of those who got spooked and to “cut their losses” missed out the bull market that followed.
Market Timers Not Only Miss the Big Days, They Also Rack Up Higher Costs
Another disadvantage of market timing is the costs you’ll assume. The more you trade, the more transaction fees you pay for. Depending on how active you are, these fees could accumulate into a significant amount.
When you do make a profitable trade, you often end up paying more in taxes than you would on a long-term gain. In the U.S, long-term capital gains (from assets held for more than a year) are taxed at a much lower rate, while short-term capital gains (investments held for only a year or less) are taxed at the investor’s ordinary income tax rate.
With market timing, you end up with a double whammy. Not only do you end up getting in and out of the market at the wrong times, you also end up having to spend more.
