On Timing the Market, Part I: Why Market Timing Doesn't Work

The evidence against trying to time the market.

Read time: 8.8 minutes

Timing the market is impossible. Give it up.

You've heard it before. But is it true? Is there any reasonable evidence to suggest that market timing is a good idea? Some people argue that timing the market is stupidity at the highest degree. We'll explore their point of view in this part. Next week, we'll look at the argument for why you should adopt a timing strategy.

Since this is the first article in the series, let's first define what we mean by "timing the market."

What does "timing the market" mean?

For these purposes, we're defining market timing to be changing your long-term investment plans because of short-term expectations about the future.

This most commonly take two forms:

  1. Someone has cash they would like to invest in stocks, but they don't think right now is a very good time for [insert reason here]. For example, someone says "Stocks are too high right now, so I'm going to wait to invest my money until after the next pullback." Or, "Is now a good time to invest?" These are attempts at timing the market.

  2. Someone is invested in stocks, but sells because they think stocks are going to fall soon. They might attach their rationale to something reasonable. A more recent one might be: "US GDP growth was -32% last month, so I'm going to sell my stocks until the economy turns positive again." Or, "Stocks have been going up for the last five years; they are due for a drop. So I'm going to sell now to take my profits and wait for the market to crash before I invest again."

9 Reasons Timing is a Bad Idea

Market timing is appealing for a lot of reasons. It's the investing equivalent of pumpkin pie without the calories. You get the upside of stock without the downside. How could that not be a good idea? After all, isn't the adage to "buy low, sell high"?

Next week, we will talk about the reasons why you might consider a market timing strategy. Today, we're going to examine nine reasons why you should think twice before trying to time the market.

1. Attempts to time the market have accounted for the vast majority of investor mistakes.

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

Dalbar's 20-year investor survey demonstrates how terrible the average investor's returns actually are. From 1998 to 2017, stocks produced 7.2% per year. A simple portfolio of 60% stocks and 40% bonds produced 6.4%. An all-bond portfolio produced 5%. Yet, the average investor managed to produce a 2.6% annual return. [1]

Let that sink in for a minute. Investors did worse than every asset class in this study. They even did worse than inflation.

Why are we so horrible at investing? The Dalbar attributes these mistakes to behavioral mistakes that cause bad timing decisions. Investors piled into technology stocks from 1998-2000. As many of these stocks (and the funds that owned them) collapsed from 2000-2003, investors lost a lot.

Once they couldn't take the pain anymore, they sold stocks and moved into bonds. Then from 2005-07, they leveraged up and bought houses and rental properties. That bubble popped in 2007, which fueled the Financial Crisis of 2008-09. As the markets collapsed, investors fled into safe assets right before the longest bull market in history started.

The cycle repeats itself over and over again. Our emotional tendency towards fear and greed drive us to make decisions at the wrong time. And that's not only applicable to retail investors like you.

2. Even so-called "experts" have failed at market timing.

It's easy to pick on retail investors for bad investing performance; even the so-called "experts" have fared poorly. According to a study by Hulbert’s Ratings, only 7 out of 244 market timing strategies outperformed a simple mechanical timing strategy. [2]

3. No one knows the future.

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

No one can know where the market is going. The future is in the future; all we can know is the past and make reasonable assumptions about likely outcomes. Anything beyond that is pure speculation.

Investors will often make a timing decision based on something they read in the news or saw on CNBC. An "expert" spews some reason why the stock market is going to collapse over the next 12 months. They sound confident and come bearing reasonable arguments. For these prognosticators, Warren Buffett (the greatest investor of all-time) has some stiff criticism:

…The only value of stock forecasters is to make fortune tellers look good…[we] believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. -Warren Buffett

Timing decisions based on subjective analysis about the future is a fool's errand. Economic forecasts are notoriously bad. Market predictions are usually worse. Even predicting political outcomes using polls of prospective votes are often wrong. No one knows anything in the future; making a timing decision based on someone's view is not a good idea.

4. Even a good strategy may not succeed.

There is evidence that some market timing strategies are quite effective. Even if you have a mechanical strategy with tons of research, it may not work.

I don’t think more than perhaps one in 100 investors will be successful using timing. -Paul Merriman

The above quote should be even more sobering considering Paul is a long-time market timer. In fact, he started a firm in 1983 that uses trend following to time the market. Yet even he says 99% of investors will fail at timing the market.

As we will see next week, the only evidence for market timing is based on following a quantitative, rules-based strategy. Yet, even that is unlikely to result in success for most investors. Why?

Even a strategy with a long-term successful track record will have periods (sometimes long ones) where they do not do well. Even timing strategies with a good 100-year track record have had decades where they did worse than buy-and-hold.

In the 10-year stretch when you're getting beat by a buy-and-hold strategy, it's going to be difficult to stick with the strategy. Ask any "value investor" how hard it can be. Most investors cannot stick with a losing strategy for long. The regret of missing out is too strong.

5. Timing the market requires watching the market, which usually leads to stupid decisions.

Market timing may exacerbate emotional biases because it requires paying close attention. Tracking short-term market trends, valuations, or other data will be time-consuming and draining. Having to watch the market's daily fluctuations can cause a great deal of anxiety. This may be enough of a reason for some people to cross it off their list.

Even if all this effort were going to work, would it be worth it? Or would that time be better spent on other investment research? Or, better yet, on earning more income so you can save more? Or, even better still, on spending time with your loved ones? There is a cost to everything and time is at the top of the list; stress isn't far behind.

If you're young and still saving, market timing is going to be a waste of time. Even the best research suggest benefits are for downside protection, not upside. Your time will be far better spent increasing your earnings power and savings skills.

A retiree with a large nest egg may benefit, however, the pressure will be high. This will compound your risks of making an emotional decision. And if you're going to adopt a timing strategy, it's imperative that it be systematic and unemotional for it to work. If you can't handle it, then it is likely wise to avoid it.

6. If timing the market worked, why wouldn't everyone do it?

Any investment strategy that works attracts competition. The easier the strategy to follow, the more that happens. If buying the lowest 50 P/E stocks in the S&P 500 worked so well, everyone would do it. Then it wouldn't work anymore.

Any strategy that has widespread and easy access to data will get erased. The only way it won't is if there are behavioral issues that prevent people from following it during losing periods. Value investors cite this as a reason value investing will keep working in the future. It's hard to follow in losing times (like now), so people abandon it right before it works again.

The same should be the case for timing. If selling stocks at the 200-day moving average worked every time, why wouldn't everyone else do it? And if everyone else did it, wouldn't it stop working?

The evidence suggests this isn't the case (more next week), but it's something to think about.

7. Successful market timing requires two correct decisions:

  1. You have to be able to anticipate future declines and act on them.

  2. You have to anticipate future increases and act on them.

As difficult as it can be to make one accurate decision about the future, making two is extremely unlikely. And making two correct decisions many times over the course of many decades? I'm skeptical.

Timing Based on Valuations Doesn't Work

The Shiller CAPE ratio has been shown to lead to lower future returns, but that doesn't necessarily equate to an effective timing model. Research on the CAPE ratio and other market valuation metrics often suffer from hindsight bias. They use data from today to prove something from the past.

For example, let's say someone said, "The average P/E ratio for the last 20 years has been 16, so it was obvious stocks were overvalued in 2007 when P/E was 17." They are using data from 2000-2020 to show that stocks were overvalued in 2007. You can't use data from 2007-2020 because you wouldn't have had that data in '07.

If you look at what data you actually had at the time, you find out that timing the market with valuation metrics is pretty much useless. Research shows that from 1900-2015, a timing strategy based upon value would have produced 0.6% excess annual returns [3]. Over 100+ years, that would be no small improvement. Unfortunately, two things overshadow that performance:

  1. That outperformance would have only existed from 1900-1958. Since 1958, the returns would have been 0.1% per year worse following the valuation timing method.

  2. Timing based on valuation had no positive impact on maximum drawdown. In fact, value timing would have resulted in an 87% maximum drawdown compared to "just" 83% for a buy-and-hold strategy.

This is Feghali and Villalon (authors of the study) discussing the research with their colleague Antti Ilmanen:

*People use data to justify market timing. But it’s hindsight bias, right? If you know ahead of time when the biggest peaks and troughs were through history, you can make any strategy look good.

So Antti and his co-authors made a more realistic and testable market timing strategy. And here’s the key difference — instead of having all hundred years of history, Antti’s strategy used only the information that was available at the time. So, say for example it’s 1996, early tech bubble. We know after the fact that the U.S. stock market would get even more expensive for a few years before it crashed. But in 1996 you wouldn’t actually know that. So by doing their study this way, Antti could get a more realistic test of value-based market timing.

The interesting and troubling result was when we did this market timing analysis the bottom line was very disappointing. It was not just underwhelming, it basically showed in the last 50-60 years, in our lifetimes, you didn’t make any money using this information.

9. If you miss the 10 best days, you do far worse.

One of the most cited arguments against market timing is that if you miss a few of the market's best days. Even being out of the market for the 10 best days you would do far worse than if you bought and hold [4].

This is a flawed argument. It is obvious that missing out on good days is costly, but you can't leave out the other side. To be fair, we should compare how an investor would have done had he or she missed out on the 10 worst days. No doubt, missing out on the 10 worst days of the market would be great for returns. But you don't see anyone using that argument for why you should never invest in stocks.

A more reasonable suggestion is that since stocks tend to go up more than they go down, the probability of missing out on up days is greater. That I'm in complete agreement with. So the point may still be somewhat valid, though imbalanced.

And a few other arguments...

There are a few more that I'll throw out there without elaborating on:

  • Following market trends has historically been a successful market timing technique, however, this may not work now that everyone has free (and constant) access to charts and data.

  • Market timing using market trends requires that the market move in long-term trends. If the market were to move sideways for a long period of time, a timing strategy would result in poor results.

  • If you sell out of stocks, you will pay taxes (assuming you sell at a gain). That more frequent selling will result in more taxes and drag your returns down vs. if you had bought and never sold. Of course, if you're in an IRA account or other tax-deferred account, then this is irrelevant.

  • Even proponents of timing strategies admit that timing doesn't improve long-term returns. We'll talk more about that next week.

Conclusion

There is compelling evidence that market timing is unlikely to be fruitful for most investors. Consider this evidence first before you decide to adopt a strategy.

"Why in the world would anyone try a timing strategy?!" If that's what you're thinking, then join us next when we look at Part II: The Evidence for Market Timing. If you want notified when that comes out, subscribe with your email below.

References:

[1] JPMorgan's "Guide to the Markets" (2019). Accessed on August 4, 2020 from: https://am.jpmorgan.com/blobcontent/1383573640089/83456/MI-GTM_4Q18_INSTL.pdf.

[2] Livingston, Brian (2019). "Opinion: Most stock-market-timing newsletters fail, comprehensive study shows." Accessed on August 4, 2020 from: https://www.marketwatch.com/story/most-stock-market-timing-newsletters-fail-comprehensive-study-shows-2019-10-29.

[3] Maggiulli, Nick (2019). "When Does Market Timing Work?" Accessed on August 4, 2020 from: https://ofdollarsanddata.com/when-does-market-timing-work/.

[4] Keram C. (2019). "Timing the Market Doesn't Work." Accessed on August 4, 2020 from: https://www.infohow.org/business-finance-employment/timing-the-market-doesnt-work/.