Advisor Blog

Once in a great while, the mainstream press manages to produce an article that provides good investment advice.  A recent article by Gary Belsky and Thomas Gilovich in Time Magazine's online edition is a great example of that rare phenomenon.  Of course, Belsky and Gilovich are not the average reporters.  They are co-authors of the book Why Smart People Make Big Money Mistakes—And How To Correct Them: Lessons from the Life-Changing Science of Behavioral Economics and Gilovich, a professor at Cornell, co-authored a previous book with Nobel Prize winning researcher Daniel Kahneman.

Market timing, somehow being able to know when to buy stocks and when to sell them based on some ability to predict the short-term future movements of capital markets has an understandable allure for investors.  Unfortunately, as the article points out, there is no evidence that anyone can do it correctly and consistently - and mistakes can be very costly.  Quite a few other experts have expressed their opinions:

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." - Warren Buffet

"If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market." - Benjamin Graham, Author and "the father of securities analysis"

"Market-timing is bunk." - Pat Dorsey, Director of Morningstar Fund Analysis

"The market timer’s Hall of Fame is an empty room." - Jane Bryant Quinn, Author, Columnist

"Market timing is a poor substitute for a long-term investment plan." - Jonathan Clements, The Wall Street Journal

"No, I don’t believe in market timing. I’ve been around this business darn near a half-century, and I know I can’t do it successfully. In fact, I don’t even know anyone who knows anyone who has ever successfully timed the market over the long term." - John Bogle, Founder of The Vanguard Group

"Nobody but nobody, has consistently guessed the direction of the bond or stock market over any meaningful length of time." - John Markese, President, AAII Journal

"There is absolutely no evidence that anyone can time the market." - Bill Bernstein, Author

"Only liars manage to always be ‘out’ during bad times and ‘in’ during good times." - Bernard Baruch, Presidential Economic Advisor

"There is an overwhelming body of evidence to support the view that believing in the ability of market timers is the equivalent of believing astrologers can predict the future." - Larry Swedroe, Author

Despite the evidence to the contrary, it seems that everyone knows someone who knows someone who correctly predicted some event that caused them to be annointed as the long sought after guru of market timing.  And, of course, there are plenty of charlatans on the radio or publishing newsletters claiming to have amazing track records of past predictions.  In many cases, it's simply a lie (many of them are not registered representatives or investment advisors and are not subject to any regulatory oversight).  In others, it's nothing more than pure chance and probability theory in action.  The example in the article uses coin flipping as a way to understand why there are usually a few "gurus" that supposedly got everything right (usually by applying some super-secret forecasting method that no one else has ever thought of before).  If you start with 1000 coin flippers and everyone flips their coin 7 times, you'll end up with 6 or 7 people that flipped nothing but heads each and every time.  Are these people particularly skilled in coin flipping?  No.  Is there a higher statistical likelihood that they will come up with heads on the next flip?  Not a bit.  Would you bet your portfolio on it?  Probably not, if you're rational and you don't want to become a Dalbar statistic.

So, why do so many people fall for the siren song of market timing?  There are many reasons.  Warren Buffet said "Investing is simple, but not easy."  Author William Bernstein, writing in The Efficient Frontier, has this to say about the ability of the average person to do the math that's necessary to understand portfolio construction and performance:  "the horsepower to do the math... The Discounted Dividend Model, or at least the Gordon Equation?  Geometric versus arithmetic return?  Standard deviation?  Correlation, for God's sake?  Fuggedaboutit!"  As we've said before, a nice story often sounds better than the truth.  But, would you bet your portfolio on a bedtime story or on 60 years of evidence-based research into capital market behavior?

Dalbar is an independent research firm that evaluates mutual fund investor returns on an annual basis.  The research uses data from the Investment Company Institute (ICI), Standard and Poor's and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks.  The annual Quantitative Analysis of Investor Behavior (QAIB) covers the time period ending December 31, 2010.

For the 17th year in a row, the study shows that both equity and fixed income investors underperformed the broad indices.  For 2010, equity investors trailed the S&P 500 by almost 1.5% and fixed income investors underperformed the Barclays Aggregate bond index by more than 3.5%.

Why do average investors underperform broad indices by such significant amounts?  The primary reason is investor behavior - reacting to market movements and news results in never staying invested long enough to derive the benefits of a long-term strategy.  Retail investors, in particular, tend to abandon investing at the most inopportune times, often in response to bad news or market corrections.

Behavioral finance experts have identified psychological factors that help explain why investors often make buy and sell decisions that contradict best practices.  These include:

• Loss aversion – expecting high returns with low risk.  Searching for investments that don’t exist, resulting in taking no action or selling at an imprudent time.

In order to achieve desirable results, investors must manage the behaviors that destroy long-term success.  Working with an advisor can often be helpful in this regard.  It is also important to understand your risk tolerance and construct a portfolio that does not exceed the level of volatility that you are comfortable with.  Taking excessive risk often leads to decisions to exit the market at exactly the wrong time.