Overcoming the temptation of timing the markets
"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
Every investor has felt the temptation of timing the market at some point:
"Should I invest now or wait for the next correction to jump in?"
"What if I invest and the market tanks?"
"This gold-guy on talk radio says that another crash is coming, maybe I should buy his book?"
Sharp slides in stock markets are unnerving, and many investors will be tempted to sell out and head for the hills, with a view to returning once the dust has settled. But that could prove a costly mistake.
A key to successful investing is resisting the impulse to time the market, and instead to hold on for the long term. Not only is market timing notoriously difficult, but staying invested when markets tumble also means you'll benefit in full by any subsequent recovery. Knowing when to buy at the very bottom of the market is just as hard as knowing when to sell at the top.
Instead, if you want to achieve your investment goals over the long term you may need to stay calm and remain invested. "It's time in the market, not timing the market."
Why timing the market doesn't work
Our trouble with market timing is due to human nature. We can be irrational and prone to panic and overconfidence. So while we may well have a long-term investment strategy, it can be hard to stick to it. We're inevitably affected by unexpected events and emotions – fear resulting from a market slump, say – and lose sight of the bigger picture.
The upshot is that, even though we ought to buy low and sell high, we often end up doing the opposite. This is partly to do with the way our brains are programmed.
We tend to draw comfort from good cheer and optimism around us, and this confidence can lead us to take more risks. But these conditions can be more common when stocks have been rising for some time, leading investors to pile in at or near the top of the market, when prices are already high. Similarly, we will be affected by widespread gloom at the bottom of a cycle, when we're more inclined to sell out, even if prices have already fallen.
So people are handicapped by the psychological tendency to get their timing wrong. This is especially awkward because successful market timing would require extreme precision, and getting it wrong can prove costly. Studies suggest that missing the market's best days over a particular timespan can make a huge difference to long-term returns.
The cost of getting it wrong
The cumulative impact of trying to time the market, compared to just buying and holding, is potentially huge. A study by Barclays found that compared to a buy-and-hold strategy, the typical investor lost 1.2% a year moving in and out of funds.
Similarly, beware of jumping into stocks just because they have fallen by a fifth in less than a year. Stock market history may be full of quick recoveries from technical bear markets, but anyone who bought in September 2008 after a 20% decline, would have suffered a further drop of almost 40% in the subsequent six months.
Bear in mind, too, that trying to time the market with individual shares or mutual funds incurs trading costs, exit loads and tax implications, and these will further undermine your odds of earning healthy returns.
Sticking to your asset allocation
The evidence strongly suggests that investors should resist the temptation to flee the market after turbulence and stick with a buy-and-hold approach to avoid missing out on long-term gains.
In this context, the best defence against volatility is maintaining a diversified portfolio, as a spread of different assets that come with varying degrees of risk will reduce the odds of your holdings being damaged by a slide in one particular market.
The different types of investments will help you achieve your own appropriate balance between risk and return, a practice known as asset allocation. Getting your asset allocation right is crucial to achieving your long-term investment goals. It depends on a number of facts, including your investment objectives, risk appetite and investment time horizon – or the time you plan to remain invested.
Take this simplified example. Shares have tended to perform better than other assets over the long-term, but they also present a higher risk of losses. In comparison, bonds tend to be less volatile, and have tended to do better when times are tough, but produced lower returns over the long term. Remember, however, that past performance is not a reliable indicator of future performance.
In reality you'll have a wider variety of assets, including property, commodities and cash, to choose from. Within these asset classes, you can also choose between sectors and regions.
In general, the longer you plan to remain invested in the market, the higher risk you must be willing to take because you will have more time to recover from a setback.
Reviewing your portfolio
It's also important to review your portfolio at regular intervals to ensure your asset allocation remains consistent with the amount of overall risk you are willing to take – and the time you are willing to spend in the market. If some assets have risen considerably, and others have fallen, the spread of your holdings will have changed from your initial allocation.
As a result, you may want to rebalance your portfolio by selling assets that have done well and buying those that have fallen. Rebalancing can therefore have a useful side effect: it makes us buy low and sell high.
Similarly, investors who have decided to systematically invest money into a market should not be put off by bear markets, as they will be buying some of their holdings at a lower price.
Bear in mind that, however well-diversified your portfolio and however long you buy and hold, the value of your investments can fall as well as rise and you may still get back less than you invested. Past performance is not a reliable guide to future performance.