Attempting to time the market—making buy and sell investment decisions based on predictions of market movements—is not the same as investing. Although human psychology tempts many investors to act like market-timing speculators, success, even among experts, is typically elusive.
Given the costs and risks associated with market timing, diversification with a long-term outlook is the better course for investors.
The Temptation—Benefit Of Hindsight
Market timing’s attractiveness stems from the human desire to discern patterns in security price movements and to avoid the painful losses of down markets. For example, an investor might notice that the stock market’s price-to-earnings ratio was relatively low at a certain time in the past, and that about a year later, stock prices were 25 percent higher. The investor may extrapolate from this observation that, if the market’s price-to-earnings ratio would return to relatively low levels, then the stocks will again appreciate over the following year. Research by Innovest and a myriad of other investment firms has not been able to identify investment firms or professional investors who have consistently linked correct decisions of when to invest in risky assets and when to move to cash.
Since accurately timing the market’s movements on a consistent basis is impossible even for professional investors, one would expect most nonprofessional investors to eschew the practice. Yet many ignore this lesson. Nobel Prize winning economist Daniel Kahneman explains why in his book Thinking, Fast And Slow. Kahneman asserts that on a psychological level, investors tend to overestimate their abilities while underestimating risk and the role that chance plays in investment performance. In other words, a good (or lucky) prediction in the past makes us overconfident that the same success can be repeated consistently.
Overconfidence resulting from success is not the only danger; experiencing losses can also be quite dangerous for market timers seeking to avoid impending downturns. Kahneman’s research has shown that investors tend to experience more regret, or psychological pain, following losses than satisfaction following gains. This tendency leaves investors more apt to sell securities after they have fallen in value and to hesitate before reinvesting. As a result, investors risk missing the periods of greatest price appreciation. The chart below, produced by Morningstar, illustrates how this hurt investors who were bitten by significant losses during the financial crisis, sold their holdings, and then hesitated to reinvest.
The Difficulty Of Timing The Market
Consistently predicting market movements over long periods of time is impossible. The recent tumble in the price of crude oil and the consequent turmoil in the stocks of oil producers illustrate how market timing can go wrong, even for experts. As shown in the chart below, the price of West Texas Intermediate crude oil reached $107 per barrel in June 2014 and fell to below $50 by early January 2015. During this time period, experts offered various price-floor predictions. As prices fell just below $80 in October, experts from major financial institutions predicted prices during the fourth quarter would range from $70 to $85. Investors who increased exposure to oil based on these predictions, which presumably were grounded in robust research, would have suffered significant losses as oil prices continued their precipitous decline through the beginning of 2015.
Market predictions made by experts in March 2001 provide a similar example. As the NASDAQ composite index reached its all-time peak of 5048.62 that month, experts from well-known securities firms predicted that the bull market would continue. One predicted that the NASDAQ would reach 6000 within eighteen months. Yet just five weeks later, the NASDAQ had fallen to 3321.29. After such a steep fall, investors may have reasoned that the index could not fall any further, and they would have found support in another expert, who opined that the index had only 200 to 300 points of downside compared to 2000 points of upside. This attempt to identify the bottom failed, however, and the NASDAQ continued falling until bottoming out at 1114.11 in October 2002.
One further illustration of how difficult it is to time the market bears mentioning: Wall Street analysts’ predictions of sector performance in 2013. At the end of 2012, Barron’s compiled the predictions of market strategists from ten major investment firms, revealing a consensus view that consumer discretionary stocks would not perform well in 2013. The predictions did not materialize, as these consumer stocks led all other sectors with a 41 percent return. Information technology was expected to be the top-performing sector in 2013, yet it ranked fifth out of the ten sectors. To be fair, the strategists made some good predictions, too. In aggregate, industrials had the second highest predicted performance and ranked third in actual performance, returning 38 percent.
Nonetheless, the aggregate views of these experts in 2013 show three or four sector bets that panned out and at least five that did not. An investor whose market timing strategy included shifting assets from sectors expected to perform poorly to those predicted to outperform would have hurt performance more than helped it.
As mentioned above, valuation metrics like price-to-earnings ratios can be misused as short-term market timing signals. We note that these metrics can benefit long-term investors who use valuations to select the most opportune times to invest. Over the long run, purchasing securities at relatively low prices can bolster returns. In contrast, the danger arises when a market timer uses these metrics to predict short-term market movements. For example, one might attempt to identify significant deviations from long-term average valuations, relying on the expectation that valuations will revert to those averages in the near future. However, mean reversion may take years to occur, and expected short-term gains may not materialize. Moreover, certain valuation metrics may never normalize. Structural changes may cause these measures to change permanently and meaningfully from past levels. For instance, in the 1990s, dividend yields were frequently used as valuation signals. As stock buybacks became a more common method of returning cash to shareholders than issuing dividends, dividend yields declined and never returned to their previous, long-term averages. Those who interpreted the low dividend yields as a bad time to invest may have been entirely misled.
Costs And Risks Associated With Market Timing
In addition to the difficulty of predicting market moves, there are significant risks and costs associated with market timing. One significant risk of market timing, alluded to above, is missing the best days in the market. A study from Morningstar, shown in the chart below, illustrates this risk. Consider the annualized 9.22 percent return experienced by those invested in the S&P 500 for the period from 1994 through 2013. Compare this return to the 5.49 percent return achieved by an investor who, in attempting to time the market, missed the ten best days during that 20-year period. Even worse, the return experienced by an investor who missed the 20 best days would have been 3.02 percent. These surprising statistics illustrate the substantial risk of being uninvested.
The risk of missing periods of strong performance applies to mutual fund investors as well. Timing purchases and redemptions of mutual fund shares based on predictions of fund performance can cause an investor’s actual performance to vary from fund performance. For instance, consider a fund that had an annualized three-year return of 15 percent. The strong return attracts an investor who decides to purchase the fund’s shares. Assume that the fund then lost 2 percent over the next year, and due to the underperformance, this investor redeemed those shares. Then, assume that the fund returned 9 percent over the year after that, yielding a healthy five-year annualized return of over 10 percent. Despite a relatively strong five-year performance, this hypothetical investor lost money by basing purchase and redemption decisions on recent performance. By merely remaining invested during the fifth year, the investor would have experienced an annualized return of over 3 percent.
Market timing can also reduce portfolio diversification and increase transaction costs. Investors who significantly alter their portfolios based on market timing signals will typically lose some benefits of diversification. Less diverse portfolios, in turn, will have higher expected volatility and thus lower risk-adjusted returns. Similarly, higher transaction costs and taxes on realized capital gains from additional trading activity erode returns.
We close with the sage words of Benjamin Graham, author of The Intelligent Investor: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.” Rather than trying to time the market, developing and—more importantly—sticking to a diversified investment policy over the long run is the recommended time-tested method of generating positive performance.
Chris Meyer is a senior analyst at Innovest and a member of the Due Diligence Group, responsible for both qualitative and quantitative manager due diligence. He is a member of Innovest’s Retirement Plan Practice Group, a specialized team that identifies best practices and implements process improvements to maximize efficiencies for retirement plan clients.