The dangers of market timing
In the aftermath of the terrorist attacks of Sept. 11, stock markets were rocked. When the New York exchanges finally re-opened on Sept. 17, it was to a wave of sell orders that drove the Dow to its worst one-week loss since 1933.
Investors were desperate to get out of stocks at any price. The market was going down, and they didn’t want to ride with it.
That kind of reaction is understandable. But it can also be dangerous to your financial health, especially if overdone. Basically, it means you are locking in losses and placing yourself on the sidelines for the rally that will eventually come.
One of the keys to investing success is proper asset allocation. That means deciding on a portfolio mix that suits your goals and your risk comfort zone and sticking with it. If you’re decided that 40% of your money should be in stocks, then stick with the strategy. Trying to get in and out by timing the market is a technique that no one, not even the most astute money manager, has perfected.
Yes, some market gurus do issue advisories from time to time to “Sell everything” in extreme conditions.
I’m not among them and never have been, for one simpleeason: no one can predict consistently and with certainty what the markets are going to do. There are thousands of people out there making informed guesses, some of whom are right more often than others. But I have yet to come across anyone who is right all the time. Every market “expert” trumpets his or her good calls. We hear nothing about the bad ones after the fact.
You don’t have to go back any farther than 1999 to find a prime example of the problem. As New Year’s Eve drew closer, attention was increasingly focused on the Y2K problem. This was a computer glitch that was built into systems long ago, in which years were expressed as two digits rather than four. At midnight on New Year’s Eve, the date would roll over from 99 to 00 — presumably leaving the computer completely confused and, perhaps thinking it meant 1900, shutting down everything. No one knew how serious Y2K would be, but some of the predictions were dire. Whole books were written on the subject, including some that urged investors to sell all their stocks and hold everything in cash in anticipation of a major world-wide computer meltdown. Some people apparently actually did just that.
Of course, as we all know, Y2K turned out to be one of the great non-events of this generation. Nothing happened. The year 2000 arrived, the computers kept humming, and the world went about its business. The only disaster was in the portfolios of those who had sold all their stocks during the previous summer. They missed out entirely on one of the strongest market rallies of the decade.
I’ve seen this sort of thing happen time and again. Forecasts of market crash fail to materialize or, when they do, the crash is followed within a few months by a big rally. If you sold everything and were out of the market when the crash occurred, chances are you were still out of the market at the time of the rally, trying to decide when to go back in.
The other main problem with market timing is a psychological one. We all have a strong tendency to base our future outlook on past experience. When this is applied to the world of money, it creates a phenomenon I call rear-view mirror investing. An example of this thinking: high-tech stocks were hot in 1998 and 1999, so they will likely continue to make big gains in 2000. Of course, anyone who followed that line of reasoning took a beating in the markets. The right approach in that case would have been to say something like: “This can’t go on forever. I’d better put my money elsewhere.” But that’s all too easy in hindsight. When the markets are going wild and investors and paying absurd prices, the natural inclination is to jump on the bandwagon.
At this point, we have no way of knowing when the markets will begin to recover from the shock of the terror attacks and its impact on the economy. All we can say with certainty is that it will happen at some point.
If you’re going to indulge in any sort of market timing, I suggest you do so through a process of portfolio rebalancing. Don’t sell out of any asset class, just reduce its weighting within parameters you’ve previously set if you feel the short-term prospects don’t look good. There are many ways to do that. For example, if you think the stock market is about to come under pressure, you could simply reduce the weighting of your growth equity funds and add to your value funds, which should perform better in those conditions. Or, if you wanted to take more decisive action, you might reduce your total equity position by 10 percentage points and put it into cash. There are many ways to adjust your portfolio to the conditions of the day without completely restructuring it or, worst of all, selling everything.
Adapted from Gordon Pape’s new book 6 Steps to $1 Million, published by Prentice Hall Canada. Order a copy at 15% off the suggested retail price