Let’s take a poll.
Raise your hand if you’ve ever heard someone brag about how they bought Amazon stock right before it’s share price doubled?
I bet there's a few of you. Okay put your hand down, people are starting to stare.
Now ask yourself this… was this person's success a matter of luck or skill? We don’t know your friend, but yea it was probably luck. Maybe best not to tell him that.
As Warren Buffett once said, “The only value of stock forecasters is to make fortune tellers look good.” The short term direction of stock prices is close to random. But why? It all comes down to human psychology and the relationship between markets and volatility.
Why “time in the market” beats “market timing”
Nobody can exactly predict a stock’s future price but that doesn’t stop many from trying to do so.
Study after study over the years has shown that “market timing” does not work and that “time in the market” is the way to go. But let’s assume you don’t want to read all those academic papers, because you know… you have a life, but you still want to understand why. Let’s start with some definitions.
What is market timing?
“Market timing” means buying a security with the expectations of selling it at a higher price in the short term. Market-timing investors are essentially trying to “beat the market” by outsmarting it - or so they think.
While market timing may initially seem to be a variant of the popular saying “buy low, sell high”, the fact that the future is uncertain and that stock prices change rapidly, means that it is basically impossible to accurately and consistently determine when a security has hit its lowest or highest point.
What does “time in the market” mean?
“Time in the market” means relying on a strategy where you don’t try to guess when the market is at its lowest or highest point. Instead, you buy the market knowing that your timing is probably going to be off, but that eventually the fundamentals matter more than the timing.
The “time in the market” investor will then stick with the market until the original reasons for buying change or they’ve reached their intended goal e.g. they're now approaching their retirement years.
Why is time in the market better than market timing?
- No one has a crystal ball
Stock prices are unpredictable. We do not know what is going to happen. And even if they were predictable, it would still be impossible to make money on investments as the market price wouldn’t budge from what everyone has calculated to be its future price.
- It's an emotional rollercoaster
People inherently want to keep track of their money. So, when it comes to investments, company stock prices and markets are fluctuating wildly on a daily basis, a market-timer may be tempted to sell their investment too quickly to capture a small profit, or to avoid a loss, despite the fact that their original theories as to why the stock may grow, haven’t changed at all.
For instance, since 1950 the S&P 500 has seen calendar year returns vary from 47% up to 39% down. This is where the human psychology component comes into play. If you got “unlucky” in 2008 trying to time the market and you were down 39%, it is very difficult emotionally speaking to reverse course and try to time the market by buying. But if you use time to your advantage, market volatility starts to wash out. Looking at the same 1950-2017 period, but looking through the lense of five year investment horizons, returns for the S&P 500 ranged from down 3% to up 28%. Even in the worst five year period, you would only have been down 3%, which is much easier to stomach than down 39%.
This is known as the “behavior gap”. Author Carl Richards states, “We're wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great. It may feel right - but it's not rational.".
Market timing easily plays on our emotions in a way that overrides dispassionate and serious investment analysis. If the reasons for your belief in a stock change, then it is important to be willing to change your investments. However, market timing easily tempts us to jump out too early or stay in too long.
- It's expensive
Frequent trading and trying to time the market will also rack up brokerage commission costs, particularly for smaller investors. While the costs for a broker to execute a trade may be relatively low on a trade-by-trade basis, someone who trades frequently can see these costs add up over time and make a significant dent in their investment returns.
Don’t forget what the goal is
It’s imperative to begin the investment process with a clear idea of what your goals are and the time frame to accomplish them. Once you do this, it should become clear that the goal is not to “beat the market” but rather to reach or exceed your personal goals. A diversified portfolio with investments that are held for a number of years has historically proven to provide greater returns than those who try to jump in and out of the market at what they believe are the lows and highs.
For more detail on investing vs. saving, check out our Investing vs. Saving Ebook.