7 Common Trading Mistakes Part 3: Market Timing
The last decade has been an emotional cliff-hanger for most investors as they see the stock market soar to higher and higher levels – along with their increasing concern that the these large increases are going to be erased when the inevitable correction occurs. This attempt to “time” markets does not make much sense when viewed without emotion. A portfolio should be selected based on being appropriate or suitable for the investor. Long-term investors should adjust portfolios only modestly unless they have experienced a major life event such as retiring or receiving a large inheritance.
When all investors are grouped together one thing becomes clear: in aggregate investors do not buy stocks more stocks than they sell or vice versa. On net, for every buyer there is a seller. So there are really three types of investors. First there are the buy-and-hold investors who resist the urge to attempt market timing and who therefore lock in average long-term returns. Then there are those who time the market well and those who time the market poorly. But note that the market timers, on average, must receive the same combined performance of the buy-and-hold investors (because all three types together must earn average returns). So investors who attempt to time the market are taking a 50%/50% chance of receiving superior or inferior performance. That means more risk without higher average return.
But the idea that market timers have a 50%/50% chance of receiving superior or inferior performance ignores three things: taxes, fees, and risk. In most situations, jumping in and out of the market causes higher taxes and higher fees. But market timing also lowers risk adjusted returns! The investor who keeps a steady position of, say, 50% of his assets in the market takes less risk than an investor who is completely in the market half the time and completely out of the market half the time. Yet the average return of both investors is the same. It is easy to see the difference in risk if we consider casino gamblers. A slot machine gambler who makes 20 bets of $5 each takes a lot more risk than a gambler who makes 100 bets of $1 each. Similarly, an investor with 50% of his money in the market for 250 trading days per year takes less risk than investor with 100% of his money in the market for 125 days and no money in the market for the other 125 days.
Market timing based on hunches is a bad strategy – it boils down to taking more risk with no added expected return.