Everyone feels the temptation to try to time the market – the stock market, the housing market, any market. It’s human nature to try to be cleverer than everyone else. And it’s only the beginning of the uphill battle we all face against the temptation to time the market.
In psychology, there’s a phenomenon known as hindsight bias or creeping determinism – or, more colloquially, the “I knew it all along” phenomenon. It’s exactly what it sounds like: People tend to look at past events and say to themselves, “All the signs were there! I should have seen that coming.”
Hindsight bias is a fallacy, and an expensive one in the case of trying to time the market. When we look at the past and believe the events should have been predictable, the next logical step is to try to predict future events. But there are always technical or market indicators to buy as well as to sell, making future predictions far harder than hindsight bias would lead you to believe.
Here are eight reasons why you as an investor should never try to time the market – and what you should do instead.
Why You Shouldn’t Try to Time the Market
Timing the market rarely works. Here’s why.
1. Tomorrow’s Dip May Still Be Higher Than Today’s Pricing
I administer a Facebook group for real estate investors, and I can’t tell you how often I see variations of this plan uttered smugly: “I’m going to wait for the next housing market dip and buy when properties are cheaper.” To which I reply, “What makes you think properties in your market will ever be cheaper?”
Yes, markets move up and down, and real estate doesn’t always go up in value. But it’s completely irrelevant because you don’t know when the high – or the subsequent low – will come
Imagine the average home in your market costs $200,000 today. You sit on the sidelines and wait for the next dip, envisioning prices dropping to $150,000. But home values continue rising for the next three years to a high of $225,000. Then, they decline to $215,000. That’s still higher than the current cost to buy. The bottom line is that today might be the best day to purchase a rental property through a website like Roofstock. The prices might never be this low again.
The same goes for stocks. When the next stock market correction comes, the nadir could still be higher than today’s pricing. You just don’t know, and no amount of technical data can unveil the future for you.
2. Sitting Out the Market Robs You of Income Yield
Real estate and stock values rise and fall; it’s true. But when you own rental properties or dividend-paying stocks, fluctuating values only account for part of your returns. In fact, when I buy rental properties, I don’t even consider future appreciation. I calculate the returns based on rental income alone and think of property appreciation as a nice bonus.
Even stock returns, known more for their price growth than their dividend payouts, rely on dividends more than most investors realize. Between 1930 and 2018, dividends made up 43% of the total return of the S&P 500, per a 2019 report by Hartford Funds. And when it comes to compounding, dividends play an even more important role: 82% of the returns from the S&P 500 since 1960 can be attributed to dividends and the returns from reinvesting them. It’s all the more reason why every investor should understand dividend stock investing.
Sit out the market, and you miss out on the income produced by investments. So start investing today. Even if you’re making small investments each month, it’s better than sitting out altogether. Open an investment account with M1 Finance and get started today.
3. Timing Leads to Emotional Investing
Nothing good comes from emotional investing. And when you try to time the market, you leave yourself vulnerable to emotion. You constantly worry if prices have fallen low enough for you to feel comfortable buying, or if they’ve soared high enough for you to sell.
That, in turn, begs a host of other questions. Chief among them: How do you determine what that magical peak or trough number – the perfect time to sell or buy – is?
You can delude yourself into thinking you’re approaching it scientifically by using some arcane data analysis. But there’s no magic formula, and most investors who try to time the market end up relying on their gut and intuition – in other words, their emotions.
4. The Stock Market Isn’t Rational
Still think there’s a magic formula out there, that if you perfectly balance technical and fundamental analysis, you’ll “crack the code”? Just because the stock market is made up of numbers, that doesn’t mean it moves based on numbers. Not entirely, anyway.
The stock market moves based on human investors. Emotional, greedy, fearful human investors who react to the news of the day and send the market soaring or spiraling downward. Apply all the formulas, logic, and math that you like, but the human element will always add unpredictability and irrationality to market swings.
All the automated trading algorithms out there don’t reduce stock market volatility. They exacerbate it, with upward or downward momentum triggering institutional purchases or sales.
Pro tip: If you want to learn more about investment analysis, check out our article Best Stock Market Investment News, Analysis & Research Sites.
5. Too-Frequent Trades Bleed You on Commissions & Taxes
All those people trying to time the market, darting in and out every time they think they see a market high or low? Their supposed cleverness leads to only one consistent winner: brokerage firms. Many charge for every purchase and sale order and laugh all the way to their own bank vaults. It’s precisely why it’s so hard to make money day trading; you must be right far more often than not just to cover the costs of frequent trades.
Another cost of frequent trades is taxes. The IRS taxes earnings on investments held for less than a year as regular income, rather than at the lower capital gains tax rate.
By following the systematic, longer-term investing approach outlined below, you can even reduce your capital gains taxes, not just your regular income taxes.
6. It’s Hard to Be Right Twice
When you try to time the market, you have two critical decisions to make. First, you need to know when to buy, at or near the low point in the market. Second, you also have to accurately assess the high point in the market and sell before disaster strikes and the market tumbles.
In other words, you have to miraculously know the market’s bottom and top to cash in on your strategy of timing the market. You have to be right about both, which is just not very likely to happen.
7. Even Economists Can’t Predict Recessions & Corrections
It’s a testament to the hubris of human nature that armchair investors often think they can predict what the market will do when even the best-informed experts in the world cannot.
Consider a 2018 study by the International Monetary Fund analyzing 153 recessions across 63 countries from 1992 to 2014. The researchers found that economists only predicted 5 of the 153 recessions by April of the preceding year. Even in rare cases when they accurately predicted a looming recession, they usually underestimated its extent.
Likewise, investment banks employ some of the smartest, best-paid financial experts in the world to predict market movements. They have access to reams of financial data that you and I don’t. And they’re still terrible at predicting market highs and lows.
Accept it: If professional economists and financial analysts can’t predict the market, you certainly can’t.
8. The Math Isn’t in Your Favor
Still tempted to try to time the market? You’ll be surprised to learn that the average stock investor dramatically underperforms the stock market as a whole. In 2018, for example, the average stock investor lost 9.42%, according to DALBAR, even though the S&P 500 lost less than half that amount at 4.38%.
And no, that’s not an aberration. Data from DALBAR shows that from 1996 to 2015, the S&P 500 offered an annualized return of 9.85% a year, but the average investor’s return was only 5.19%.
The reason: investors’ all-too-human behavior. Trying to time the market and only succeeding in buying when everyone else was buying, then selling when everyone else was panicking. Every time they attempted it, their purchase and sell orders bled them on commissions.
By contrast, a buy-and-hold investor with the worst timing in history would still outperform the average investor handily. Consider fictional investor Amy. Amy invested $50,000 in the S&P 500 at the peak of the market, just before each of the four worst bear markets of the last 50 years:
- Investment 1: $50,000 in December 1972 (just before a 48% crash)
- Investment 2: $50,000 in August 1987 (just before a 34% crash)
- Investment 3: $50,000 in December 1999 (just before a 49% crash)
- Investment 4: $50,000 in October 2007 (just before a 52% crash)
Even though she had terrible purchase timing, Amy didn’t panic sell but automatically reinvested her dividends. By May 2019, her four investments had grown to $3,894,503. Not a bad nest egg, considering Amy only invested $200,000, and at the worst possible times to boot.
What to Do Instead of Timing the Market
It should now be clear that trying to time the market is a losing proposition.
The good news is that the alternatives are actually far easier and require less work and attention on your part. Consider it a double win; you earn higher returns by doing less work, all for the cost of resisting the emotions of fear and greed.
1. Dollar-Cost Average
One of the ways to reduce risk in your stock portfolio is to practice dollar-cost averaging. If that sounds like some complicated technical process, fret not. It’s just a fancy investing term for buying the same funds or stocks, in equal quantities, at a regular interval.
For example, I buy shares in the same handful of funds every single month on the second Monday of the month. It removes all decisions and emotions from the equation. I know what to buy, when, and in what quantities.
When the market rises higher, I feel good that my net worth is higher. When the market dips lower, I feel good about buying stocks at a discount. I’m happy no matter what happens, and I don’t have to spend more than five minutes per month thinking about my stocks if I don’t want to.
M1 Finance makes this simple because they automate everything for you. You set your schedule, and they handle the rest of the work.
2. Buy Index Funds
Unlike actively managed mutual funds, index funds passively track stock indexes such as the S&P 500. The fund managers charge very little for expense ratios because there’s almost no work involved on their part. That means you lose less of your money to fees and keep more of it invested to grow and compound.
Even better, invest through a brokerage that offers high-quality, commission-free index funds. Avoiding the commissions takes the sting out of dollar-cost averaging as you buy a handful of funds every month. I personally use Charles Schwab, but Vanguard offers excellent funds as well.
Sure, you could dollar-cost average with individual stocks. But that’s a higher-risk, higher-labor game and fails to protect you through diversification.
3. Buy Funds With Your Tax-Sheltered Retirement Accounts
When you buy funds in a retirement account such as an IRA or 401(k), you benefit from the tax advantages. But as great as those are, these retirement accounts also come with less tangible psychological benefits.
Because account holders can’t withdraw funds until age 59 ½ without incurring a penalty, most tend to let these accounts grow and compound in peace. They don’t feel the same mother-hen temptation to watch and cluck over their account’s performance constantly – or to try to time the market.
Pro tip: If you have a 401(k) plan through your employer, sign up for a free analysis from Blooom. They look at your plan’s diversification and asset allocation to make sure they line up with your goals. They also pay attention to the fees you’re paying.
4. Invest in Real Estate for Income, Not Growth
There’s no need to time the market. When you invest for income, the underlying value of the asset can rise or fall, and it doesn’t hurt you as long as you keep earning money. Take real estate during the 2008 housing crisis as an example. Data from the Federal Reserve shows that home values dropped nationwide by an average of 27.42%, yet rents didn’t fall at all.
In other words, an investor who bought a rental property based on the cash flow in 2007 would still earn the same cash flow throughout the entire Great Recession. Who cares if the property’s value dropped? Income investors don’t lose sleep over it because they still earn money every month.
5. Adjust Your Asset Allocation As You Age
As older adults near retirement, they become vulnerable to sequence of returns risk, or the risk of a crash early in their retirement. Even if you do everything right and avoid worrying about timing the market, timing suddenly becomes relevant when you retire.
But the answer isn’t to try and time the market; it’s to prepare your portfolio so that it can withstand a crash.
You do this by rebalancing your portfolio as you near retirement in favor of a less volatile, more income-oriented asset allocation. Typically, that means shifting money away from stocks and into bonds, but bonds aren’t your only option. Alternative asset classes include high-dividend stocks and funds, rental properties, REITs, mREITs, and other sources of passive income.
6. If You Must Get Fancy, Pick Stocks Rather Than Timing
Some people can’t help themselves; they love stock tickers, following markets, and researching trends. Often, it’s these better-informed investors who are most tempted to time the market – and hurt their returns in the process.
If you love financial markets, put your passion to work for you by researching individual stock picks. Find the diamonds in the rough and invest by dollar-cost averaging. (If you want help finding good companies to invest in, I recommend Motley Fool Stock Advisor.)
You can beat the market, but it’s much easier to do so by picking winner stocks than it is by trying to time the market.
It’s not often that the way to earn more money is to do less work. Stock investing should be boring. It should be more like watching a tree grow than watching an action movie with plot reversals and intrigue.
For investors who crave a more active role, pick individual stocks and invest in real estate. You can put in all the work you like and earn accordingly.
But for everyone else, who’d rather slog through “War and Peace” than The Wall Street Journal, forget timing the market and follow the steps above. You’ll earn more money and more time with your friends and family by escaping the addiction of the stock ticker.
Still disagree about timing the market? What have your experiences been, and how do you make timing decisions in your investing?