FIRE Finance: The Mistake Of Timing The Market

Edit Post Wednesday, January 19, 2011

Feb 09, 2012: Have you ever wondered about the fact that even after a decade long relationship, sometimes it seems that we hardly know the other person! Sounds familiar isn't it? If the behavior of a single human being can be so unpredictable then what is our take about the cumulative behavior of millions of investors all over the world? Our observation is that such behavior is utterly unpredictable and apparently irrational!

We sometimes ponder and try to speculate the market. Basically we try to time the market to maximize our gains. Often we give up in despair! There are so many factors to be taken into account, volumes of information to be considered (not all of them are all reliable either) and finally there is a humongous number of unknown parameters that may influence the market! How on earth does one tackle all that?

We believe it's simply not possible to successfully time the market consistently over a long period of time. We have friends who try to do so. They hope to profit on the upswing and sell out during the downward movement of the market. Then there are those who get in and out at the drop of a hat aka the average impulsive investors.

Which strategy do you think is the most rewarding: buy and hold, impulsive or market timing? Here is some evidence to enlighten us in this regard. Let us study the following chart.

It depicts annualized average returns for a 20 year period from 1984 to 2003.
Three different investor behaviors are considered - buy and hold, impulsive and market timing.
The first set of bars show investments made in a 100% stock mutual fund.
The scenario for investing in a 100% bond mutual fund is shown in the second set.
Inflation has not been accounted for. Average annual inflation for 1984-2003 was 3.1%.
Buy and hold investor simply bought a S&P 500 Index fund for stocks and Lehman Brothers Long Term Government Bond Index fund for bonds.
Dividends were reinvested.

Surprising isn't it? Not once in our wildest imaginations did it occur to us that market timed investing would be the worst performer. But this set of data says so! Amusingly we notice that the average impulsive investor did better than those who tried to time the market!

We encourage you to do your own research and determine a suitable strategy for yourself. It would be extremely interesting to know about your findings. Please share your opinions with us.

Data Source(s): Dalbar Inc., Quantitative Analysis of Investor Behavior, 2004.

Image Source(s): iStockPhoto

Adventures In Money Making said...

sorry, but i'll disagree with you.

if you read Ben Stein's excellent book "yes, you can time the market" he despells the myth that market timing doesn't work.

what is market timing? its buying something thats undervalued and selling it when its overvalued. (its not buying it on monday and selling it on the following thursday).

if you don't know how to analyze stocks, and you buy just because your bro-in-law said so, then yes, timing will not work for you.

other than that, its just a myth perpetuated by wall street.

Anonymous said...

In most cases, you are correct, market timing won't work over the long haul. Under certain circumstances, it can work.

Here's an example. I like to watch "Mad Money". On some days, Kramer particularly bad-mouths a stock. When this happens, the goes down for a day or 2. I buy after that. Then dell it when it settles back to the position it shoud be in. Now, I don't have enough money in it to get rich or anything, but after about 80 trades my annualized gains average about 15.6% (discounding for tradign commissions). As with anything else, you cna get burned some times.

So, maybe the secret is that you have to have a target sucker. In this case, it is betting againse the impulsive.

FIRE Finance said...

Thanks a lot to all of you for sharing your thoughtful views. Inspired by your comments we wrote this post :-)
FIRE Finance

Interesting post. FWIW, I agree with it. I plan to include your article in my weekly carnival review this Friday.

Best Wishes,
D4L

@D4L
Glad that you liked the post and thanks for covering it in your carnival review.

Penny Stocks said...

I really like this blog post, it has some great info. Thank you and keep up good work.

Jacob @ My Personal Finance Journey said...

I love how market timing generated a negative return! No doubt in my mind that is true. I would also add that the returns of passive investing in the mutual fund can be improved by rebalancing your set asset allocation several times a year in response to market fluctuations.

Jeff Voudrie, CFP® Professional said...

The real question is whether the average investor ever received those returns. Here's an excerpt from my book that also refers to a Dalbar study:

WALL STREET Myths Continued
Biggest Myth #2: You’re Better Off When You Follow Their Advice

The second biggest myth that the Wall Street System needs you to believe is that you will be better off financially if you follow their advice. Isn’t that what they are trying to say in all of their advertising?

The truth is that research has shown that following the advice of the Wall Street System won’t produce the returns they say you should expect. Dalbar is the industry standard in investor-return research. Dalbar looked at the returns of the S&P 500 compared to the average investor over the best 20-year period in stock market history, from 1985 to 2005. Since the average investors looks to the Wall Street System, it gives us a good idea of the effectiveness of that advice. More importantly, this study doesn’t focus on just the advice of the advisors but essentially shows the overall impact of the entire Wall Street System. So it includes the financial media, the financial product companies and the sales force.

If those following the advice of the financial media did well, this report would show it. If the financial product companies designed products that really helped the investor, this study would show it. If the Wall Street System sales force portraying itself as knowledgeable advisors was effective, this report would show it.

Instead, the numbers show that there is a tremendous gap between the return of an unmanaged index (the S&P 500) and that of the average investor.

As you can see in this chart, over the 20 year period ending in 2005, the S&P index with dividends returned 11.9% per year whereas the average investor return was only 3.7%. Inflation averaged 3% per year. This chart is pretty impressive but it doesn’t show the cumulative impact of this difference in returns. Look at this chart:

Assuming an initial investment of $100,000, the ending value for the unmanaged S&P 500 with dividends would have been $947,549. The average investor’s $100,000 would have grown to only $206,812. Of course the inflation-adjusted value of the $100,000 was $180,611 so the average investor barely kept up with rising prices.

Here’s the shocker. This study is based on retirement plan investors. In other words, the 401(k)’s used in company retirement plans. The fees charged in those plans are minimal compared to the fees paid by investors in the Wall Street System. Let’s assume the fees in the Wall Street System were even just 1% greater than in the 401(k) plans—and they could easily have been 2% or 3% more each year.
Reducing the average 401(k) investor return by 1% to simulate what may have occurred in the Wall Street System, the investor return would have been $170,376, meaning that on an inflation-adjusted basis they would have lost money.

How have you done investing within the Wall Street System? Do these numbers bear any semblance of reality with your experience? I’ve talked to many, many retired investors and it seemed that their actual returns were barely keeping up with inflation—if they did that well.

How Successful Investors Tripled The S&P 500: The SECRET to Stop Playing By Wall Street's Rules, End Your Frustration... by Jeffrey Voudrie

The Mistake Of Timing The Market

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