Wednesday, June 6, 2012

The Problem With Timing the Market

Timing the market might sound attractive, in retrospect, but in real life, it is a risky thing to do.

In the last two years, I had two chances to time the market, and in retrospect, it seems like it would have been a good idea to do so.   But I did not, and I am kind of glad I didn't try it, as my time machine is out of order.

What do I mean by this?   Well, last summer, you may recall the debt ceiling standoff, which as an artificially created "crises" orchestrated by Rep. Boehner to create chaos and make a point.  He made his point - Congressional approval ratings are lower than our unemployment rate, as our stock market lost all its gains for the year.

And in the last week, stocks tanked on renewed FEAR of the European Debt crises.  Both events were well telegraphed in advance, and in theory, at least, I could have "sold it all" and bought it all back, and made a hefty profit in the short term.  But I didn't, and here's why.

First, it is tempting to say, "I saw it coming, why didn't I act?" when you view events in retrospect.  Time machines are deceitful things, and you may think you saw it coming, but in reality, you didn't.  The retrospective view is a poor perspective.

Second, suppose you decide to "Sell it All" and get out of the market, based on a "hunch" that the market will go down - and it doesn't?

For example, say you think the market is going to drop.   You log onto your investment account, which has $100,000 in it and sell all your 10 stocks, incurring $100 in trading fees, and park your money in a "safe" FDIC insured money-market account earning no interest.

But then a funny thing happens - your hunch is WRONG and the market doesn't tank, but continues to climb by 1%.  At this point, you are in a bit of a pickle.   You will now lose $200 in trading fees buying all those stocks back, and pay $1000 more to buy the same stocks.   So now, your $100,000 investment is worth $98,800, just because you churned your own account.

On the other hand, if the market had gone down as much as 1.2%, you would be in the same place.  So the two possible outcomes (market going down, market going up) end up being about the same - you lose money.

Now, if you sold the stocks and the market remains flat or goes up, you may be tempted to say, "Well, geez, maybe I timed it wrong.  I'll hold out longer and see what happens!"   So you wait a month or two, for the "big crash" that Motley Fool told you about, and it doesn't happen.  Now stocks are up even higher, and if you try to "buy back in" you will be even worse off than before!

And the longer you wait, the longer you will have to play "catch-up" to try to get back to where your portfolio should have been if you had kept the stocks.   And what might happen (and realistically DOES happen to many of us) is that you will realize that your "hunch" was wrong, and then panic-buy once prices go up, thinking that you need to "get back in, to see some of those gains" and at that point, the market then does decline, and you've done the classic "buy high, sell low" game that depletes the accounts of so many small investors.

On the other hand, if you had kept your stocks, you would be realizing all those gains.   And if the market goes down, you would be in no worse shape than if you had sold.

It creates a four-position decision matrix.  And as you can see, the matrix favors keeping stocks:

There are four possible outcomes here.  One is really good, one not quite as good, and the other two are nearly equally bad, with one being slightly worse than the others.  Of course, this decision matrix doesn't factor in what happens in the long-term.  If you can time both ends of the transaction, so you buy back in at the right time, you make out.  But if you fail to time both the buy and sell right, you may end up losing more.

Over the last week, we have seen the market drop by several percentage points.  Yesterday, and today, they have bounced back, somewhat.  Yes, it would be nice to have a time machine to know when to sell and when to buy back in - you could end up doubling your positions in some stocks in no time.

But the risk is, if you try this, and miss those high and low marks you will end up falling behind the position you would have been in, if you left well enough alone.

Timing the market is not investing, it is gambling.