Does Market Timing Work?

The increase in Internet connectivity in the past two decades has brought with it countless benefits in terms of productivity and access to knowledge. It has also brought investors 24/7 access to stock market news as well as their investment portfolios. This level of access can be useful, but overexposure can often leave investors feeling panicked or that they need to ‘do something’—to time the market. ‘Market timing’ is the practice of attempting to get in and out of stocks and raise cash as a shorter-term tactical strategy to avoid a market correction. We should be clear that we view ‘market timing’ as an issue separate from longer term decisions for each client, such as asset allocation, risk tolerance or liquidity needs.

We don’t believe investors—and we include ourselves in that lot—are much good at ‘market timing.’ We’re not saying that simply because numerous academic studies and the data support this view, but because the arguments against it also intuitively make sense. If pinballing repeatedly between stocks and cash/bonds to enhance our clients’ long-term returns were practical, we would gladly do it! However, in practice, it’s been proven to more often do damage to clients’ long-term returns. Here are some of the problematic issues around market timing:

  1. It requires you to be right, not once, but twice: sell and get out at the right time, and then buy and get back in at the right time—fail to do either and by definition—you are falling behind.
  2. Showing up is more than half the battle. A 42-year study at the University of Michigan showed that less than 1% of the days the stock market was open (i.e. the ‘best days’) accounted for more than 95% of the S&P’s long term +9.2% return. Conversely, missing the 20 ‘worst days' also dramatically enhanced returns. Twenty days on either end equals less than 1% of the thousands of trading days observed, thus the odds against successful market timing are staggeringly high.
  3. Frictional costs: jumping in and out of stocks means incurring trading costs, capital gains taxes and potentially foregoing the benefit of dividend payments. Over longer periods, these costs have been shown to hurt compound returns.
  4. Market efficiency/human behavior: “buy low, sell high?” Sounds like a great plan, but in practice it often means running afoul of Points 1-3 above. The average investor dislikes buying into a steep selloff or parting with ‘winners’ that have a ‘halo’ around them. The market also has a habit of incorporating (over-incorporating actually) bad news extremely efficiently and rapidly.

As stewards of our clients’ capital, our job is to make sure investments and asset allocation are suitably aligned with clients’ end goals. With respect to stocks, the goal is to compound client wealth at as high a rate as possible with the least amount of risk. To this end, we believe the best route to delivering superior returns is for us to focus on predicting those first two components of stock returns mentioned earlier: earnings and dividends. We try to make that job easier by identifying great businesses at an attractive price. Market timing is really the practice of trying to anticipate the third component: changes in what people will pay for stocks. This is a far less predictable exercise and easier to get wrong—because it’s driven by shifts in investor psychology around fear and greed that are tough to predict.

These quotes from some recognizable names in investing align with our own views:

“ Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” –Peter Lynch

“ We continue to make more money when snoring than when active.” –Warren Buffet

“ In the financial markets, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.” –Benjamin Graham