Market Timing: A Losing Strategy
We would like to spend the entirety of this first post discussing a reoccurring question we receive: “Why can’t you just ride the market to its peak and then exit right before the inevitable correction?”
We understand where this question is coming from. Market timing is an intriguing concept on the surface – if we sell right before a market dip and buy right before a market rally, we all get rich, right? The problem is that no investor in history has ever been able to achieve this level of market timing success over an extended period, for reasons that will become apparent. After all, if predicting the next recession was easy, there would be no shortage of economist billionaires.
The goal of this post is to explain why consistently timing the market is impossible, why this actually doesn’t matter for investment performance in the long run, and where our time as investors is better focused.
And in case you’re still not completely convinced on the premise, consider the annual Dalbar study on investor behavior which finds that the average equity investor under-performed the assets they were investing in by 6.18% over a thirty-year period. The main reason being that investors jumped in and out of the assets at the wrong times – namely, they tried to time the market. The study isn’t perfect, but it does demonstrate the point.
Why Consistently Timing the Market is Impossible
There are 4 main concepts that will help you understand why consistently timing the market is impossible:
The academic/theoretical answer. Markets are mostly efficient which means that information that can be used to predict a company’s future has already largely been incorporated into today’s price. Therefore, only unforeseen events can affect stock prices, and unforeseen events are unpredictable by definition.
The concept of “Reflexivity” which was popularized by George Soros, and is more grounded in reality. It states that a two-way feedback loop exists in which investors’ perceptions affect the environment, which in turn changes investor perceptions. In other words, if investors think something will happen, they bet in that direction, changing the risk/return dynamics of the market, reducing the payoff of being right, and changing what investors think will happen. Imagine aiming at a target, where the act of aiming changes where the target will be.
The sheer number of variables at play in the market are computationally intractable. Some of those variables are obvious; geopolitical news, economic releases, and individual company factors, but that is just scratching the surface. Consider things like the weather, floods, hurricanes, earthquakes, international money flows, regulatory rulings, technological advances, terrorist attacks and even the tone of the media. Most of the time these variables are sending competing signals that are chaotic and unpredictable.
And arguably the most important concept; the idea that the market is made up of individuals and all the emotional irrationality that comes with them. There is something about the market where every few years everyone forgets that markets can go down as well as up. It is hard enough trying to figure out what economic releases are saying about the future of the economy, but if market participants are just going to ignore it anyway and chase the most recent get rich quick fad, it just adds another layer of unpredictability. As Isaac Newton said, “I can calculate the motion of heavenly bodies, but not the madness of people.”
These factors all coalesce and create an adaptive complex environment that isn’t conducive to predictions. If you actually track the records of TV pundits who make predictions on a regular basis, you’ll find that on average they do worse than a coin flip. Some may be right occasionally, but none are ever right consistently.
Why it Doesn't Matter in the Long Run
One of the world’s greatest investors, Warren Buffett, is known for having a favorite holding period of forever. This is likely because no one knows what will happen in the next year or two, for reasons we've discussed, but over the long run, things get fairly predictable. Consider the following:
The above chart shows the probability of capital loss over different time horizons for the S&P 500. Note that as time increases, the likelihood of loss decreases. It follows that if we are patient as investors (don’t panic during downturns) and avoid excessive risk (don’t get greedy during upturns), that we should do well over time.
Of course, this assumes that we don't succumb to our emotions during the short-term random ebbs and flows of the market.
Where Our Time is Better Focused
If our job as investors isn’t to time the market in the short run, what is it?
Every day we get bombarded by news and pundits making predictions about where the price of oil or interest rates will be three months from now. Most of this is noise and can be readily ignored. Instead of getting caught up in this short-term mindset, we should remember to focus on what is “important and knowable.”
There are a lot of things in the world that are important but unknowable. For example, what the stock market will do over the next year is important information, but unknowable. Similarly, it would be important to know if a nuclear bomb was going to go off tomorrow, but that just isn’t possible.
What is important and knowable? An individual company’s business model, sustainable earnings, competitive dynamics, quality of their management and everything else we glean through in-depth fundamental research. Over time, these important and knowable characteristics are the most significant predictors of future returns. Over the short run, the majority of stock price movements are based purely on the sentiment level of investors. Whereas over the long run, earnings become the single most important driver of returns.
Too many investors waste their time focusing on that first part, which is unpredictable. Instead, we focus on that second part, which is both predictable and important. Like Benjamin Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
This is where our edge as investors comes from: Analyzing companies and thinking about what their earnings power will be over the next 5, 10, 15 or 20 years, not trying to read the tea leaves.
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