In the last couple of articles, we’ve covered what to focus on as a long term investor, investing during a downturn, and where the sharemarket might be in the future.
But many people think that, in addition to our regular investing, we should also build up extra cash to “buy the dip” when markets fall. And while this sounds great in theory, there are some issues with the idea in practice.
In fact, there’s so much to say about this topic that we’ll explore it in two parts. Today's article will explore why timing the market is a fundamentally bad approach for the everyday investor. First, let’s start with why timing the market is such an attractive idea.
The seduction of market timing
The idea of timing the market is so alluring that it sweeps up many new investors in its charms. Generally, people are seduced into trying to time the market for two reasons:
- It sounds easy. Step 1. See news about a coming crash or recession. Step 2. Stop your regular purchasing and maybe even sell existing shares. Step 3. Wait for the fall. Step 4. Buy back in at lower prices, and make a killing when the market rises again.
- We’re greedy or scared. Greedy, because we want to make higher than average returns to speed up our wealth-building journey. We’d love to sit back, wait, and then plough all our cash in at the bottom of the market. And scared, because who wouldn’t like to avoid seeing their portfolio fall sharply in value?
It sounds like it makes sense. So, what’s the problem?
Problem 1: Recession forecasts are endless
If you’ve been investing for just a few years, you’ll have noticed the number of dire predictions. Usually they focus on a coming recession, the risks we face, or the go-to headline: ‘crisis looms’.
It’s like this every… single… year. And if you pay attention to it, not only is it exhausting, but it’s self-defeating. Why? Because the fear of what might happen will stop you from doing what matters, which is focusing on increasing your investments and achieving your goals.
This also means that you can’t expect any special signals or insights on what the market will do next. No amount of news-watching will help you become wealthier. It won’t increase your returns. In fact, the habit will only serve to stress you out and cause you to second-guess your actions.
I would even argue your success as an investor is inversely related to how much news you watch. Yes, wealthy investors have more dollars at stake. However, they also know that current news events are irrelevant to their long term wealth.
If you’re a new investor, understand these stories are not unique. It’s the same doomsday journalism that’s peddled out every year. The truth is, there are always risks on the horizon, always things that could happen. But we have to invest anyway, because we can never know how the events of the universe will unfold. Here’s another, related problem.
Problem 2: If it was that simple, everyone would do it
We’re all hearing the same news. We all see the same expert predictions. And so do the professionals in the share market. There are no secrets. In fact, as regular people, we have less insight into the mechanics of the market. As a result, we have an even lower chance of deciphering the thousands of economic data points emerging every month.
Every day, thousands of analysts are pouring over information in an attempt to quantify the future earnings for each company. This means that if we are headed into a recession, it’s very likely that shares are already pricing in that expectation.
So, why would our casual checking of financial news lead to an intuition that others don’t have? The whole idea is preposterous, and if you think about it, a bit arrogant.
Just like trying to pick the best stocks of the next 10 years, trying to guess the market’s moves over the next ten months is absurdly unlikely. But guess what? Some people will get it right. It just won’t be the same people each time. Even a broken clock is right twice a day.
Why timing the market is likely to fail
Any effort to time the market involves having or building up ‘cash on the sidelines’. This creates an issue. Historically, cash in the bank has tended to produce lower long term returns than the share market. As such, we expect this to, on average, create a ‘drag’ on an investor's return.
“Yes, but the market might go down and having cash will work out better.”
True. But how likely is that? Well, according to Market Index, since 1900 the Australian share market has delivered positive returns on 81% of all years. Therefore, the chance of a negative return over a 12 month period is 19%. By trying to time the market, we’re betting against the fact that most years the market simply pays dividends and increases in value.
In fact, the most common range of return over a one year period is +10% to +20%. The market tends to reward investors over time, with a few painful setbacks along the way. Our job is not to avoid the downturns, but to accept them and prosper through them. We do this by maintaining the right perspective, and focusing on the things within our control.
Finance writer Nick Maggiulli runs the numbers on timing the market in his epic post 'Even God Couldn't Beat Dollar-Cost Averaging':
“Buy the Dip, even with perfect information, typically underperforms DCA. So if you attempt to build up cash and buy at the next bottom, you will likely be worse off than if you had bought every month. Why? Because while you wait for the next dip, the market is likely to keep rising and leave you behind.”
How to benefit from market drops
Here’s something that might surprise you: an investor who is dollar-cost averaging is already timing the market without even knowing it. Let me explain.
Say you’re buying $1,000 worth of XYZ Fund every month (a fund I just made up). XYZ’s shares trade at $1.00 each, so this month’s purchase got you 1,000 shares.
Over the next month, the market declines horribly and shares in XYZ Fund fall to $0.80. Your regular $1,000 investment goes through as normal. Except because the price is lower, your $1,000 investment now purchases 1,250 shares instead of the 1,000 it acquired last month.
In this case, the same dollars buy 25% more shares than before. As the market falls, your money stretches further, and the longer this continues, the more you can buy. When the market eventually recovers, more of your portfolio will have been bought at lower prices because of the sheer quantity of shares you’re able to buy during market declines.
So you could, in fact, set up a goal or target using this FI calculator (which incorporates your income, expenses, super, investment amount, and so on). From there, you could automate your monthly investing. Lastly, you could go sit on the beach while effortlessly enjoying the market-timing benefits of dollar-cost averaging!
Does timing the market ever make sense?
The version of timing the market where someone is jumping in and out of the market like a wiry-haired trader is, for the reasons outlined in this article, a horrible idea. But there is a much milder form of timing the market which isn’t quite as bad.
The less damaging approach is to stick with your regular investing, whilst keeping some extra cash for market dips. And if that’s what you feel most comfortable with, then it’s probably okay. After all, it’s not like that will make or break the end result.
We each have our own unique personality traits, risk tolerance, and comfort zones. Our investment plan should be tailored to that. Having this mental comforter (and ability to buy more shares) might be what helps you stay the course during a scary time in the market. And if it does, then it’ll prove to be worth it.
Just be aware that the extra cash is likely to put a small drag on returns. And it might be harder than you expect to put that money in when stocks are falling. After all, you may agonise over whether it’s the right time or not.
Final thoughts
I hope this post has highlighted some of the issues with trying to time the market. And while we can’t control what the market does, we can control how we behave as investors.
Focus on your goals, stick with the plan, and measure your success by how much you add to your portfolio. Sometimes, it’s all about process over progress. The returns will come in time.
Overall, there are numerous things working against us when it comes to timing the market. More often than not, these efforts have resulted in lower long term returns.
But maybe you’re still not convinced. In that case, stay tuned for my next article, where I’ll explore a couple of market timing strategies. We’ll also flesh out the challenges faced when trying to time the market in practice.
Until next time, happy investing!
