Investment Returns and Market Timing

Given the extreme swings in stock prices, wouldn’t it be better just to get out of stocks before they go down, and reinvest in them before they go back up?

Forget about it! That’s called market timing and it can’t be done. Despite the tens of thousands of highly paid Wall Street professionals spending all their working hours studying the stock market, nobody has been able to consistently predict when the market will turn up or down. Successful market timing requires that you make two correct guesses—when to sell stocks and then when to buy back in. And it is critical that you make that second call correctly. For example, according to economist and mathematician Benoit Mandelbrot, in his book The (Mis)Behavior of Markets, during the 1980s, 40% of the gains in the S&P 500 occurred on just 10 trading days; miss those days and you miss a big chunk of stocks’ performance. The risks of being out of the market when it goes up actually exceed the risks of being in the market when it goes down.

Here’s a little fable as to why it is foolish to think you can guess right where all others have failed. I owe this to an example appearing in Roger Gibson’s brilliant investment book Asset Allocation.

Imagine that you begin January 1, 1926 with $10,000 to invest. Now imagine that you are successfully able to guess correctly whether the upcoming month is going to be good for stocks or bad. When you sense that stocks will outperform cash, you keep your assets in stocks, specifically in the stocks that make up the S&P 500. When you sense that cash will perform better than stocks in the upcoming month, you sell and move your assets into cash. By the end of 2007 your account would be worth over $400 trillion, more than thirty times the actual market value of the S&P 500, clearly an impossibility. If you could successfully predict the direction of the market, your wealth would grow so large that your trading would influence the market.

The moral of the story is to find your appropriate asset allocation and then stick to it, rather than to try outguessing Mr. Market.