I tell people all the time that they can’t time the market. But if I’m honest with myself, I don’t think most believe me. When I say that almost no one can beat the stock market consistently, what they really hear is that “other people” can’t.
Even people that agree with me verbally often secretly feel, somewhere down in their gut region, that they know which direction the market is moving in. Their gut feelings are backed up by any number of websites, books and paid retreats that offer “can’t-lose systems” for winning at investing.
Let’s forget for a second that this gut feeling is usually nothing more than the mainstream media’s consensus smushed like peanut butter into the folds of our brains. Let’s even imagine for a minute that there exists a human being who can accurately guess which direction the stock market is going. We’ll call this person Tim. Tim has an invaluable skill: he can identify an overvalued stock market the way I can identify a sentence fragment.
Is this enough to make Tim a rich man? My guess is no. Even with this truly impressive skill, the deck is still stacked against Tim, because this skill alone is not enough. In order to be successful Tim has to do four things right in a row:
1. Identify the high point.
Markets are in a constant tension between sellers and buyers, and the price of a stock at any given time is a reflection of the proportion of buyers versus sellers. These buyers and sellers include financial companies and institutional investors who research equities for a living. To properly identify an overvalued market, Tim has to know something all of these companies do not. We’ve already established that he does (as unlikely as that may be). But it’s more than that, because stock markets can stay overvalued for years, rise, and become even more overvalued. Tim has to pinpoint the actual high, the point at which the market can no longer be irrational. The peak just before the drop.
2. Actually Sell Something “High.”
It’s not enough just for Tim to believe he’s identified the high point in the stock market. He actually has to put his money where his mouth is and sell something. This involves logging into his brokerage or mutual fund website and executing a trade. This sounds simple but it’s surprising how often this step trips up the market timer. When it’s easier to do nothing, taking action can be difficult. And what should Tim sell? And how much? Selling just a few shares won’t make a big impact, but selling everything would be a reckless bet.
When he actually does sell, any stocks sold for a gain will trigger capital gains tax. This will eat into his profit from any market timing moves. Selling for a loss will avoid those taxes, but it will lock in a loss, not exactly what you want when you’re trying to make money in the stock market. And selling probably brings its own trading costs, though not in all cases.
3. Actually Buy Something “Low.”
So Tim has sold some equities and he’s feeling pretty good. He’s got cash sitting in a money market account now, just waiting to pounce on a good deal. We’ve already established that the stock market was high, so unless there’s another type of investment that’s undervalued and can be bought right away, Tim’s going to have to wait for a time.
Unfortunately, time and cash are not great friends. Inflation is all over the map, but averages out to around 2% per year. By this logic, cash sitting in a money market account is losing roughly 2% per year in purchasing power.
So with his money dribbling away slowly as from a leaky faucet, Tim now has to reverse his superpower. He’s got to identify undervalued assets. And not just that they’re undervalued, but that they’re at their lowest value and about to rebound. Remember that to make money he has to properly time the sell and the buy. And he actually has to log in and buy the undervalued stock, likely generating a trading fee.
Are you exhausted yet? I am. But there’s more:
4. Track His Rate of Return Versus a Benchmark and Include Taxes.
This is something that investors of all stripes fail at time and again. People simply don’t track their real performance, because it takes work and too often reveals uncomfortable truths. If you ask someone how their investments are doing, they often step right into their cherry-picker and get to work telling you about their latest “big win.”
It’s easy to tell someone that you put a thousand dollars into the stock market and pulled out two thousand. It’s a great story and it makes you look smart. But what if the whole stock market more than doubled during that period? You don’t look so smart anymore – just average. The only way to properly rate your performance is to determine the real rate of return from all your buying and selling and plot it against a benchmark: something like the S&P 500 or Russell 2000, or ACWI if you have international holdings. Some investing software can do this easily. Sometimes you have to roll up your sleeves and put everything into a spreadsheet (I do this, it takes a ton of work - I’m a bit of a kook). And if you did a lot of buying and selling, you have to consider the drag of capital gains tax and fees against your performance.
When this process is done right, it often reveals disappointing, or merely average performance. If Tim performed worse than a major index, it would have been much easier and more profitable to just buy that index. If he did the same or better, how much better did he do? Was it worth all of the extra work? And more importantly, will it be repeatable over the long term?
So if it’s moderately difficult to do any of the four steps above, doing all four in a row is incredibly hard. As the track record of mutual funds shows, even most well paid professionals cannot do it with any regularity. Unfortunately, I don’t think Tim can either.
I use this chart so often that I have it saved on the desktop of my computer. It’s a graph of the value of the S&P 500 since 1970.
I could show you others: the Dow or the Russell 2000. With all due respect to Tim, going up against any of these benchmarks is like boxing against Mike Tyson in his heyday in the 80s. Since the trend of the stock market over time is relentless upward motion, anyone who tries to buy and sell their way to success has to be remarkably surgical about it. Looking at the chart, the reason is obvious: There are far more up years than down. So while a seller’s money sits on the sideline, there’s a good chance the stock market is rising without them. Add in transaction fees, inflation, taxes and loss of dividends, and Tim is not just trying to box Mike Tyson. He’s fighting without gloves.
Disclaimer: The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Clients may lose money. Past performance is not indicative of future results. Investments in securities involve the risk of loss. Any tax strategies discussed should not be interpreted as tax advice and do not represent in any manner that the tax consequences detailed will be obtained. Clients should consult with their personal tax advisors regarding the tax consequences of investing.