The Costly Consequences of Trying to Out Guess the Market

Very few investors, if any, can consistently predict changes in market direction. No one was prepared for the crash of 2008 or, more recently, 2020, which is why crashes happen. Precipitous drops in the market happen unexpectedly, which is why they usually trigger panic selling, and small investors get trampled in the stampede. When the stock market recovers, many investors wait to see if it will be a sustained recovery or a "sucker" rally.

The dirty secret among professional investors is that when small investors panic and exit the market, it’s time to buy, and when the small investor re-enters the market, it’s time to sell. Yet, many investors still hold onto the notion that they can call the shift and make the right move at the right time.

Market Timing Often Leads to Investing Underperformance

Decades of investor data confirm that trying to time the market—moving in and out of the market to avoid declines—typically leads to underperformance. But that doesn’t deter many fund managers who attempt to do it regularly and have poor results to show for it.

The reason for that underperformance is that, while they may succeed in missing out on the worst days of the market, they are likely to also miss out on the best days, which often occur close to the worst days.

A study by Fidelity Investments showed the impact on returns when investors missed out on the best days out of more than 10,000 trading days (roughly a 20-year period). An investment of $10,000 in the S&P 500 index between January 1, 2000, and March 30, 2020, generated nearly 700% gains. But if you missed the ten best days of the market during that period, your gain would be less than half that. If you missed the 30 best days, you would have realized just over a 100% gain.

So, while it may feel comforting to know you missed out on the worst days of the market, you’ll worsen your long-term investment performance because, very often, the biggest gains in the market occur soon after the worst declines.

What makes market timing so tricky is that to outperform the market, investors must be able to make the right decision twice—when to get out and when to get back in—which is challenging to do with any level of consistency. A study by Dalbar shows that the 20-year annualized return of the average equity mutual fund investor unperformed the 20-year annualized return of the S&P 500 by nearly 5% due almost entirely to terrible market timing choices.

Can the Potential Gains ever be Worth the Real Costs?

Nobody will probably ever admit it, but most of us are lousy timers, and of course, none of us can predict the future. How often have you tried to shift your way through stop-and-go freeway traffic only to end up in the slowest lane? For investors, the actual costs of lost time and opportunity are almost always greater than the potential benefit of shifting in and out of the market. We would all be served well by heeding Warren Buffett’s observation that "A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person making the prediction."