A perennial temptation for investors is the urge to quit the market at the top and to get back in at the bottom. While the lure of market timing sells millions of books and is standard fodder for financial TV shows, the reality rarely lives up to the promise.
History is littered with the failed dreams of market timers. Less than five years after the nadir of the financial crisis, some pundits were saying US stocks were over-valued. Another five years on and the market had gained more than 60%.
Not even the gurus have much of a record. Back in 1996, Federal Reserve chairman Alan Greenspan warned of ‘irrational exuberance’ in the stock market. But we now know that the market went on climbing for three years before the dot-com bubble burst.
Even if your logic about valuations is impeccable, there’s no guarantee the market will come around to your view. As the great UK economist and investor John Maynard Keynes once said, markets can stay irrational longer than you can stay solvent.
But the most overlooked challenge with market timing is that it requires you to make two correct decisions: Firstly, you must get out at the right time. Secondly, and often more challengingly, you must know when to get back in.
Think back to the global financial crisis. Plenty of people were throwing in the towel by early 2009. But how many got back in in time to enjoy the big bounce that followed in the second and third quarter of that year?
The fact is markets don’t move in a straight line and big gains (and losses) can come in relatively short periods. Not even the professionals have much of a track record in successfully negotiating these unpredictable twists and turns.
So, if market timing is a mirage, what can you do? There are a few ways of looking at this challenge and none require you to possess a crystal ball.
The first is to build an asset allocation – a mix of stocks, bonds, property and cash – that is designed for your risk appetite and that is sufficiently diversified so that you are not taking too much of a bet in one area. Ultimately, it is the structure of your portfolio that is going to be the most important driver of your investment outcome.
A second way of thinking about this challenge is to ditch the idea that you are either all in on the market or all out. For instance, a defensively-minded person may only have 50% of their portfolio in stocks, with the rest in governments bonds and cash. The mix also depends on your age, circumstances, goals and time horizon.
A third point is that no-one says you just sit there without changing position. However, the changes that you make to your portfolio are ideally done in a strategic, structured and disciplined way that reflects your own needs and circumstances.
This is called periodic portfolio rebalancing. Say you have 70% of your investments in stocks and the other 30% in bonds. After a year of big gains in equity markets, the growth part of your portfolio has done so well that you discover your equity allocation has increased to 80%. In this case, you take some of that money out of stocks and put it into government bonds to restore your original balance.
This is a much better strategy that falling victim to knee-jerk responses to the latest bout of market volatility, which inevitably involve emotional, short-term decision-making.
Finally, if you really are wary of the market and loathe to stake your entire pot, you can “dollar cost average”. This just means that instead of going all in, you drip feed small amounts into the market over a longer period.
Incidentally, financial economists don’t think this approach makes much of a difference from an investment perspective, but it can help deal with regret risk – our inbuilt tendency to place a greater weight on possible losses than on gains.
In summary, timing the market – while superficially an attractive idea – is fraught with danger. If you get lucky, great, but there’s no method to it. We’ve seen that not even the gurus are much good at it.
The good news is that through maintaining a strategic asset allocation, diversification, periodic rebalancing, discipline and dollar cost averaging you can achieve a much better result while making the ride much less of an emotional rollercoaster.