Topic: Daily Advice

What every investor must know about stock market timing

When stock prices are highly volatile and bad news (strikes and national bankruptcy risk in Europe, the threat of war in Korea, risk of Japanese-style deflation in North America) seems to be everywhere, it’s natural to wonder if you should sell all or part of your portfolio and simply hold the cash until things look clearer.

Going into cash can, of course, relieve stress. You might even get lucky — prices may fall after you sell, and you may manage to buy back in at a lower price. But in the long run, following a stock market timing strategy of going back and forth between stocks and cash is virtually certain to cost you money.

How could it be otherwise? After all, if you could consistently spot good times to get in or out of the market, you could consistently make 10% to 20% per year on your money — more if you employed leverage. So why would you work? Why would anybody work?

This same principle guarantees that you’ll eventually lose money as a short-term trader, regardless of whether you try to trade stocks, or futures, or foreign currencies.

Studies show stock market timing strategies consistently underperform the market

Dalbar Inc., a U.S. research firm, has studied actual investor returns for a number of years and has consistently found that investors fail to keep up with the market because they try to improve their returns through stock market timing.

The firm found that in the 20 years ending in 2008, the Standard & Poor’s 500 index had an average compound return of 8.35% a year. The average investor had an average hold period of three to four years within those two decades, and earned an average compound return of 1.87% a year. That’s a fraction of the gain in the market, and also well below the average inflation rate of 2.89%. Results for in-and-out bond investors were worse.

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The best stock market timing discipline you can practice is to buy consistently during your working years, and sell your holdings off gradually in retirement. Meanwhile, collect dividends, and buy and sell only in response to clear fundamental factors.

The best risk-cutting method you can employ is to follow our three-part Successful Investor strategy:

  1. Invest mainly in well-established companies, which generally have a long history of profits and dividends;
  2. Spread your money out across the five main economic sectors — Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities. That way you share in the profit of the best-performing groups, and you avoid overindulging in the laggards.
  3. Avoid or downplay stocks that are in the broker/public-relations limelight. This limelight tends to push up expectations and prices, and this guarantees deep declines during the inevitable earnings disappointments.

Above all, overcome the temptation to think that you can succeed as a fair-weather investor — one who is in the market when prices are going up and out of the market during the inevitable downturns. If you try to do that, you will wind up selling when much of the damage is done, and buying back in when much of the recovery has already taken place.

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