The major online brokerage platforms have seen an increase in new accounts and trading activity as a result of investors seeing recent market turbulence as a buying opportunity. The lure of getting in at the right time or avoiding the next downturn has led to many investors trying to time the market. Market timing is akin to sports betting, and while we may not have a football season this upcoming fall to entertain us on Sunday afternoons, we can use this parallel to educate clients on the downfalls of market timing.
Although you may be able to identify the winning team in a few games every week, that may not be enough to make money, as you may need to cover the spread. The spread levels the field by giving the underdog extra points and is set by bookkeepers so that there is an equal amount bet on each team. To make money betting against the spread you must know when the spread is wrong – betting on the underdog when the market has overestimated the favorites advantage, and betting on the favorite when the market has underestimated its advantage. Timing the market works the same way.
It’s not enough to correctly forecast that the economy will expand or that we are going into a recession. Just like the bookies spread, stock prices incorporate the aggregate forecasts of market participants. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time an investor can react to it. For market timers to win, they need to figure out not only what the forecast is, but also whether the forecast is too high or too low. Making the problem even harder, no one knows what forecast the market has priced in.
Back in March, there was widespread agreement that COVID-19 would have a negative impact on the economy, but to what extent? Who would've guessed we would've experienced the fastest bear market in history in which it took just 16 trading days for the S&P 500 to close down 20% from a peak only to be followed by the best 50-day rally in history? I would be hard pressed to find someone who had that in their market timing forecast.
There are additional frictions that need to be considered with market timing. For example, relative to a static asset mix, market timing will typically incur higher turnover and trading costs from moving in and out of asset classes. Additionally, frequent trading, particularly for shorter holding periods, can have implications for taxable accounts because of differences in the treatment of short-term and long-term capital gains. Trading costs and tax implications increase the performance hurdle required to make market timing worth pursuing.
The data suggests that attempting to time the market may reduce investors’ gains over time. Dimensional's research team conducted simulations using hypothetical timing strategies that switch from US stocks into US Treasury bills after market downturns of various magnitude and switch back to US stocks following different lengths of time out of the market. Compared to the market’s long-term annualized return of 9.57%, nearly all of the timing strategies underperform the simple buy-and-hold strategy.
When betting, you know the spread you’re betting against; in the stock market, you’re betting what the spread is. For investors trying to time the market, the odds are stacked against you; the good news is, you don’t need to be able to time markets to have a positive investment experience.
“Dimensional” refers to the Dimensional Fund Advisors LP. Past performance is no guarantee of future returns.