All about investments, personal finance and well-being! But almost always based on academic research.
The time has come to analyze the investment strategy that, most likely, every investor has applied at some time in his life: "Market Timing". In case you don't know it, market timing corresponds to the practice of trying to anticipate falls or rises in the price of an asset or market. It seeks to exit the investment at the right time and start investing at the best times. The ultimate goal is to earn higher returns than you would if you kept investing at all times.
I'm going to give you the bottom line right now: you can't stay ahead of the market's ups and downs successfully and consistently over the long term. Just don't try it, you will end up greatly damaging your expected returns. In order to properly understand why practices like market timing are harmful, we must study 2 areas: What statistics say about market timing and confirmation bias.
Academic literature and Market Timing
The paper "Market Timing: Sin a Little", written by Cliff Asnessa, Antti Ilmanenb and Thomas Maloneyc in 2017, studied the impact that stock valuations have on future stock returns. The objective was to analyze if the current valuation of a stock allowed us to predict its possible future returns. To study this, they built an investment strategy based on stock valuations and tested it from 1900 to 2015. Their results were very interesting.
It was found that, from 1900 to 1957, the strategy did deliver higher returns than just buying and holding the market. However, from 1958 to 2015 the strategy failed and underperformed the market.
Looking at that data, we might think that 57 years of outperforms might be worth the risk, but thinking this way is cheating. An investor who had applied this strategy in 1900 could not have guessed that for 57 years he would beat the market, and you, who are investing right now, cannot guess what stock returns will be like in the next 50 years.
Imagine that you are an investor in 1952 and you are about to implement this strategy. You review the historical data and see that the strategy has beaten the market by 52 years! You invest, you have good years, and you would have no way of knowing that, from 1958 forward, it would not beat the market. The worst thing is, in that same example, you might see 1 or 2 bad years after 1958 and think, "It does not matter, there have been bad years in the past, what's a couple of not so good years next to 50 great years? You probably already have an idea of the problem.
We simply cannot successfully and consistently anticipate the falls and rises of the markets. In the long term, we will obtain less returns than the market if we try to do market timing (and this without considering buying and selling costs and taxes). On the other hand, in the short term stock returns are mostly random. This means that it is totally normal for investors to beat the market for several years just by chance and luck.
The above leads us to the second edge to analyze: The great damage that is generated by doing market timing and being successful.
The worst thing that can happen to you when applying a market timing strategy (getting ahead of a market downturn, investing in the best times, etc.) is that you succeed. Yes, you read that right, in this case success is the problem.
By the above I mean that, by being successful at market timing, we will most likely suffer from a powerful and unavoidable psychological bias: The confirmation bias.
Confirmation bias is the tendency to favor, seek, interpret, and remember information that confirms our own beliefs or hypotheses, giving disproportionately less consideration to possible alternatives.
In the world of investments this bias has clear appearances. If you try to predict some fall or rise, and you are successful, you will tend to think that it is because of your skill or talent as an investor. If you manage to obtain higher returns than the market doing market timing for several years, you will most likely believe that it is due to your great preparation, skill and talent, when in fact, it is statistically normal that many investors in the world do it for a while (due to just random). However, these results are not sustained in the long term and, sooner or later, your returns will go down either quickly or slowly. Also, trying to predict which investors or institutions (such as mutual funds) will be the ones that, by chance, beat the market for years is also a strategy that will give you bad results in the long run (we will see this in future articles).
Our emotions could become our worst enemy if we don't make decisions based on data.
Something I didn't go into detail about in this article is the fact that the days with the best returns in stocks tend to come during periods of economic downturns, if you try to get out of the market during a downturn, you will have to re-enter later. Missing out on a few of those best days can greatly hurt your returns in the long run. I will analyze this in more detail in the article that I will write about economic crises.
As you can see, trying to understand why it is not possible to predict the falls and rises of the market is not an easy task mentally speaking, especially in periods of economic crisis or high volatility. Even the most rational and experienced investor will feel some anxiety when his portfolio falls rapidly in some crisis. No one can help but feel these emotions, because we are humans, not robots. What we can do is understand our portfolio and understand the statistics and psychology behind the strategies that seek to anticipate falls and rises in the market.
Even if with all of the above and many years of experience you still feel too much anxiety and fear, then most likely your portfolio has too much risk for you. Consider the inclusion of instruments such as bonds to reduce volatility.
I hope you liked and found this article useful. Stay tuned as I will be analyzing many areas of the investment world, but always from an academic perspective.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Nicolas Hidalgo