Why timing the market is a risky investment strategy

Investors are often told – sometimes jokingly – that the key to making money from the stock market is to “buy low, sell high”. On the other hand, we’re also told that active trading is for mugs – “buy and hold” is best. In effect, it’s “timing the market” versus “time IN the market”. So which is best?

Timing isn't everything

A while back, some US researchers at the Schwab Center for Investment Research looked at this debate and put some hard numbers on the cost of becoming overconfident in your trading skills. They looked at what would happen under various investment styles to an investor who received $2,000 every year for 20 years to invest in markets, a total of $40,000. The perfect timer who put money into the market at its low point every month ended up with $387,120. Sounds great – until you realise that the autopilot investor who invested money on the same day every month, with no sweating about market timing, boasted a return of $362,185.

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In 1998 meanwhile, researchers at the University of Utah and Duke University reviewed the performance of 132 investment newsletter portfolios – whose entire existence is dedicated to market timing – between 1983 and 1995. It was a good period for the US market, and the average return the newsletter writers made was 12% a year. Yet if you’d just stuck your money in a bog standard US equity markets fund instead, you’d have got 16.8% a year.

Perhaps the managers running the really big money might do better than the newsletter writers? Let’s see. Over the last few decades, we’ve seen the emergence of hedge fund managers as the new masters of the universe, managing countless tens of billions of dollars. The idea behind hedge funds is that these traders can deploy any number of ideas and strategies to “beat the market” – but for most of them, some element of market timing is crucial.

Hedge funds use their research and intelligence to time a purchase so that they can make the maximum return. It sounds great. The only problem is that countless studies have shown that most hedge funds have consistently failed to sustain outperformance. If these traders with their huge resources struggle, what hope is there for the rest of us with a normal, non-master of the universe job?

The power of patience

“Buy and hold” investing may not allow you to charge the large fees that hedge funds do. However, it can mean both a calmer life and better returns than if you try to time your exposure to markets. “Buy and hold” is all about being patient and maximising your time in the market. This builds on the understanding that while markets can be volatile, if you have a sufficiently long-time frame, then you can ride out the ups and downs in sentiment.

Better yet, this long-term, patient approach can help to prevent you from making many common mistakes. Chasing performance – buying assets once they have already done well – is just one trapdoor which many investors fall down. The Economist magazine once looked at how two investors would have fared between 1900 and 2000, had they started with just $1 each. At the start of each year, the first investor – with impeccable timing – put all of her money into that year’s best-performing asset class. The second investor – with the benefit of hindsight – put his money into the previous year’s best performer.

What was the result? The first investor ended up with a net worth of more than $1.3 quadrillion. The second – the performance chaser – turned his dollar into just $783. And this is the problem with market timing – you are likely to choose the wrong investments just as often as you choose the right ones.

Underpinning all this is the commonsense idea that you need to base your investment decisions on patient research, and to diversify your risk. Warren Buffett is arguably the world’s greatest investor, and has attracted many plaudits for his undoubted acumen and ability to stay calm and invest when those around him are panicking. But even he has argued that for most investors a straightforward, diversified bet on a basket of large equities is probably safer. Moreover, what Buffett’s own experience does teach us – through the success of his giant Berkshire Hathaway investment vehicle over the last four decades – is that investing in good quality, well-run companies, with decent balance sheets and sound business principles, is not likely to go too wrong over the long term.

In short, when it comes to long-term investing, it makes a lot more sense to put your faith in “time in the market”, than in “market timing”.

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