Is Trying to Time the Market a Bad Idea?

Trying to time the stock market, or making investment decisions based on short-term market movements, is generally considered a bad idea and can be a riskier investment strategy. This is because the stock market is inherently unpredictable, and can be impacted by a wide range of factors, such as macroeconomic data releases, political events, unexpected news, institutional transactions, and even rumours, which can cause sudden and significant price fluctuations.

When investors try to time the market, they often make decisions based on short-term market movements, rather than considering the long-term prospects of the underlying companies. This can lead to suboptimal investment outcomes and increased risk, as they may miss out on opportunities for returns.

In contrast, a long-term, buy-and-hold investment strategy has been shown to be a more effective and less risky approach for most investors. This strategy involves investing in a diversified portfolio of stocks and holding onto those investments for an extended period of time, rather than trying to make short-term trades based on market movements.

While it's not possible to completely eliminate market risk, a long-term investment approach can help to mitigate the effects of short term market volatility and increase the chances of achieving long-term investment success. Additionally, a well-diversified investment portfolio can help to spread risk across a range of assets and minimise the impact of market fluctuations.

There is a significant body of academic research and historical data that supports the theory that timing the stock market is a bad idea and that a long-term investment approach is more effective. Some of the evidence to support this conclusion includes:

1. Dalbar: One of the most well-known studies that highlights the problems with stock market timing is the "Dalbar Study". The study, which has been conducted annually since 1994 by the investment research firm Dalbar, Inc., compares the performance of individual investors to a benchmark index, such as the S&P 500. The study consistently shows that individual investors underperform the benchmark index due to their tendency to time the market and make impulsive investment decisions. The 2020 Dalbar Study found that the average equity mutual fund investor underperformed the S&P 500 by 4.5% per year over the 20-year period from 2000 to 2019. This underperformance was primarily due to the tendency of investors to buy high and sell low, which is often a result of market timing and emotional decision making.

   
   The Dalbar Study is often cited as evidence of the difficulties associated with stock market timing and the importance of a long-term investment approach. The study has been heavily discussed and debated in the financial community and is widely regarded as one of the most comprehensive assessments of individual investor behaviour.




2. "The Case against Market Timing" by Roger G. Ibbotson and Paul D. Kaplan, published in the Financial Analysts Journal, analysed the performance of market timers versus buy-and-hold investors using data from 1926 to 2003. The study found that market timers underperformed buy-and-hold investors by an average of 4.5% per year.

   
   Additionally, the study found that market timing was particularly ineffective during periods of high market volatility, with market timers underperforming buy-and-hold investors by an average of 7.6% per year during these periods. The authors concluded that market timing is a challenging and difficult strategy that is likely to result in lower returns for individual investors.

   
   The authors suggest that a passive, long-term investment approach is a more effective way to achieve long-term financial goals.




3. "Market Timing and Mutual Fund Performance" by Hsu, Chen, and Kao, published in the Journal of Financial Economics, analysed the performance of mutual funds that employ market timing strategies. The study found that mutual funds that engaged in market timing had an average return that was 1.44% per year lower than those that employed a passive buy-and-hold strategy.

   
   The authors also found that the returns of mutual funds that employed market timing were more volatile, with higher standard deviation and lower Sharpe ratios compared to those of passive funds. The study concluded that market timing is a costly and ineffective investment strategy that leads to lower returns for individual investors.




4. University of Michigan:: In a study over the period from 1963 to 2012, they found market timing cost investors an average of 2.5% per year in foregone returns. The study found that investors tended to sell stocks after a decline, and buy stocks after a rise, which led to significant underperformance over time.




5. Blackrock found that investors who moved in and out of the stock market tended to underperform those who remained invested over the long term. The study found that investors who were out of the market during the best 10 trading days each year between 1994 and 2014 would have earned an average annualized return of 2.6%, compared to 9.8% for those who remained invested.




6. Morningstarfound that market timing was the primary driver of underperformance for actively managed mutual funds over the 10-year period from 2011 to 2020. The study found that investors tended to chase performance by buying funds after they had already experienced strong returns, and selling funds after they had experienced poor returns.

Collectively, these studies draw the following conclusions.

1. Market timing is difficult: Predicting the direction and timing of stock market movements is an extremely difficult task and even the most experienced investors struggle to do so consistently. Most investors are not able to consistently time the market in a way that generates positive returns.




2. Long-term investing has proven to be effective: Historical data shows that a long-term investment approach has been effective for many investors. For example, a study by JP Morgan Asset Management found that since 1926, an investor who remained invested in the stock market would have earned an average annual return of 9.8%.




3. Market timing can lead to missed opportunities: When investors try to time the market, they often miss out on periods of strong market performance, which can have a significant impact on their long-term investment returns.




4. Market timing is often associated with increased costs: Market timing can often result in increased transaction costs, such as brokerage fees and taxes, which can reduce investment returns.




5. Emotional factors can impact market timing: The emotional factors associated with market timing, such as fear and greed, can also impact investment decisions and lead to suboptimal outcomes. Additionally, the frequent buying and selling associated with market timing can increase the risk of making emotional, impulsive investment decisions.

In conclusion, while some investors may be able to time the market successfully, the evidence suggests that this is a difficult task and that a long-term investment approach is a more effective and less risky strategy for most investors.

As market timing generally leads to underperformance, especially during times of market volatility, for most investors it should not be considered. For some professionals, there may be exceptional situations in which it can be considered, remembering that market timing during periods of high volatility usually leads to especially large underperformance.