The economic weather is getting worse, so you might feel the urge to take control and do something about it. You might feel like selling your stocks until things blow over.
This is a very common and very big mistake. I mentioned it in passing in an email two years ago but it bears repeating, especially now.
It’s a big mistake because typically people sell their stocks when things are at their scariest – when worried-looking traders are on the front pages and TV news.
Then having sold, people tend to wait until things are looking a bit safer before buying back in. So they sell at the bottom of the market, and buy back when things are on the mend.
Relatedly, people tend to throw money into the market when everything is looking golden and the market is hitting all-time highs. It feels like the safest time to invest.
But of course that feeling isn’t to be trusted. Putting cash into the market when it feels safe, and taking it out when it feels risky, is another way of saying buying high and selling low.
It’s a big mistake because it’s so common and it has big consequences. Friesen and Sapp (2007) looked into it.
They compared the returns that would be earned by a buy-and-hold investor in mutual funds, and the cash returns investors in those same funds actually make. The difference between the two numbers is accounted for by investors’ decision when to put money into the funds and when to take it out.
The study found that timing decisions dragged investors annual performance by 1.56 per cent per year, compared to a sit-on-your-hands, buy-and-hold strategy.
1.56 per cent is a bigger drag than it appears to be. Say a buy-and-hold strategy returns 6.0 per cent per year. Over 30 years, a 1.56 per cent drag shrinks the ultimate size of the pot by 36 per cent.
And bear in mind, this study I’m referring to is of investment professionals. Retail investors probably do even worse.
There’s one reason why market timing doesn’t work, and another reason why it’s actively harmful.
Market timing doesn’t work, in the sense that it doesn’t improve performance, because markets are very, very efficient at processing new information. Whatever smart insight you think you have about the way things are going, the all-seeing eye of the market will have long ago processed it and incorporated it into prices.
That’s why the first sign of an impending crisis is always a stock market crash. The market sees where things are headed before they happen. By the time Russian cavalry rolled over the border into Ukraine on February 24, the Russian stock market had already tanked 43 per cent. Since then, it has fallen only 11 per cent. By the time the normies have figured out what’s going on, the market is onto the next thing.
The reason market timing is actively harmful is because stocks have a slight wind at their back. In the short run, they bounce around unpredictably. But in the long run they go up by five to ten per cent or so per year. So for every month your money is parked on the sidelines, in cash, it’s missing out on that tailwind. And even if the market seems like it’s crashing, you have no reliable way of knowing whether worse is ahead. All you know for sure is that the tailwind exists.
This little game drives the point home. It lets you trade a random 10-year period in the US stock market. You can buy and sell when you want. The goal is to beat a buy-and-hold strategy.
I played it five times and I managed to beat buy-and-hold once — through only selling once, and getting lucky with the timing. Those are the kind of odds you’re looking at. And of course the more times you sell and buy back in, the harder it is to beat buy-and-hold. When I made myself trade in and out twice, my record fell to zero successes in five attempts.
There are two times when it’s okay to sell. One is when you’re rebalancing. Rebalancing is about fiddling with your portfolio to keep it in line with your goals and risk appetite.
Say you’re near retirement and your goal is to have a portfolio of 50 per cent bonds and 50 per cent stocks. If stocks go on a crazy five-year run whereby they double in value, your portfolio will now be 67 per cent stocks and 33 per cent bonds. That’s good in that your portfolio is bigger – but it’s also riskier, because of the higher proportion of stocks. So to stick to your original strategy, and risk appetite, you sell some of your stocks and buy bonds, such that you end up back at the 50/50 allocation.
Rebalancing your portfolio periodically is a good idea. The only thing about it is that the trades incur transaction costs. How much should you do it? It makes sense to keep an eye on the size of allocation for each asset, and rebalance whenever they get out of whack.
The other time to sell, of course, is when it’s finally time to swap financial assets for the things that really matter — university tuition fees, or an extension, or a jet ski, or whatever floats your boat.