Market timing is an investing strategy where investors move their money in and out of the market to try and avoid losses before they happen and buy-in at the bottom after the market has crashed. It’s the well known tactic of ‘buy low and sell high’.
It all sounds fine in theory, but timing the market rarely works in practice. Let’s explore why.
What goes wrong?
Market timing strategies are usually put in place when the market is high. People think that ‘what goes up, must come down’ so they panic. But there is also such a thing as momentum. If shares have been rising, they can continue to rise for some time.
The risk of trying to time the market is that you may sell too early and buy back in too late. This could result in your money being out of the market at the very time that it surges, meaning you would miss out on the best performing months.
Investment managers Schroders have researched the performance of three indices that reflected the performance of the UK stock market, the FTSE 100, the FTSE 250 and the FTSE All Share.
They found that if you had invested £1,000 in the FTSE 250 at the beginning of 1989 and left the investment untouched for the next 30 years, it might have been worth £26,831 by the end of that period (N.B past performance is no guarantee of future returns).
If, however, you had tried to time the market and missed out on the 30 best days, the same investment would have been worth £7,543 – a difference of £19, 288 (with no adjustment for charges or inflation). Take a look at the different results:
11.6% per year if you stayed invested the whole time
9.6% per year if you missed the 10 best days
8.2% per year if you missed the 20 best days
7.0% per year if you missed the 30 best days
The difference in percentages may seem quite small but when you consider the compounding effect over the years, it becomes quite substantial.
Successful market timing is only possible if you know exactly when to pull your money out of the stock market and when to put it back in. And none of us has a crystal ball.
So why is it tempting?
Rationally, we know that it’s exceptionally difficult to time the markets. We know that volatility is just part and parcel of investing. We know we should be in it for the long haul but it’s difficult not to make a knee-jerk reaction, if we think the markets are going to plummet.
As humans we suffer from cognitive biases, one of which is loss aversion. We hate losing more than we love winning. So if we look at the market and fear there is going to be a major crash, it’s very difficult to sit back and watch our hard-earned money disappear. Sticking to a long-term investment strategy takes discipline and courage.
We’re also prone to overconfidence. Even if we know deep down that market timing rarely works, we’re tempted to try and prove otherwise. We’ll be the exception to the rule, we tell ourselves.
Time in the market
There is always going to be some risk in investing in the stock market. That’s why the returns are higher than with something like government bonds. But trying to avoid the inherent risk of investing through timing the markets can open up even more risk.
Some years will inevitably be worse than others but the example above shows that time in the market is more significant than timing the market. A long-term investment strategy is likely to win out over dipping in and out.