The folly of trying to time the stock market
Do you think that now is a good time to invest in the stock market?
When asked this question, most market commentators respond with a cautionary statement that largely avoids the issue.
Some examples include:
“The market is at an all-time high.” Given inflation and positive real economic growth, the absolute level of the market should regularly be at all-time highs. This tells you nothing.
“We are living in uncertain times.” The future is always unknown, so we are always living in uncertain times. The only thing that changes is the degree to which people worry about this.
“If we have a market correction, you will be glad you didn’t invest.” A blindingly obvious, and unhelpful, statement.
Why is it that so many people find it hard to answer the question directly? Cognitive psychologists teach us that, when confronted with an uncertain outcome, most people are incapable of thinking in terms of probabilities. We focus far more on the consequences of a short-term loss than on the probability of a long-term gain. This mental bias has been labelled “myopic loss aversion.”
Consequently, those answering the question above are afraid of being seen to be wrong in the short term, even if they might be correct in the long term. And, to those asking the question, an answer that addresses their fear of a short term loss will generally sound more appropriate, and perhaps more intelligent, than a reasoned answer – particularly if the reasoned answer sounds even mildly optimistic.
However, for an answer to be helpful, it must be based not on fear, but rather on known facts and likely probabilities.
Let’s assume the person asking the question has a planning horizon of 20 years (shorter than most investors’ horizon) and is interested in investing only in the broader stock market, rather than individual stocks.
We know at least two things. First, while, in the short run, stock market returns rise and fall, often dramatically, they are reasonably predictable when measured over longer periods. On average, the broader stock market has returned more than 9 per cent per annum over the past 50 years. This is a far higher return than that produced over the same period by a portfolio of bonds, real estate or any other asset class. Even a 7 per cent annual return doubles your capital every 10 years. Over 20 years, the additional annual return that stocks provide makes a huge difference to your wealth and ability to retire comfortably.
Second, we all overestimate our ability to predict the near term future. Many independent studies have proven that no one is able to predict the short-term direction of the stock market – even at times like the present, when public companies are trading at historically high valuation multiples.
Therefore, the rational answer to the opening question, assuming the questioner wishes to maximize his or her returns over the long run, is: “Now, or pretty much any time, is a good time to invest in stocks.”
We suspect that most readers will feel uncomfortable with this answer, given the cognitive biases to which we are all subject. There are, however, at least two psychological tools that you can use to overcome these expensive biases.
One is to invest your funds in the stock market over time. For example, you could invest 20 per cent of your capital every three months until it is all invested. This way, if the market falls before you are fully invested, you will be glad you moved slowly and, if it rises, you will participate, to some extent, in the gains.
Alternatively, or additionally, you could maintain a buffer account of cash or cash equivalents equal to, say, three years of living expenses – and invest the balance of your capital in the stock market. As the market rises over time, the buffer account can be replenished using sale proceeds from your stock portfolio. If the market declines, you can wait for it to come back, which it always does, before selling stocks to top up your buffer account.
The key point to remember is that timing the market doesn’t work.
What works is time in the market.