Frequently Asked Questions (FAQs)
Q: Why don't you incorporate market timing
into your strategies? Is dollar-cost averaging a good idea?
A: Market timing sounds great in theory,
but in practice it not only fails to improve investment performance,
it usually reduces investment performance (more on
that later).
The idea of market timing is to remove an
investment from a financial market when the market is near
the "top." Then wait until the market is at the
"bottom" and move the money back into the market.
Continue the process over and over, buying low and selling
high (all the while paying trading commissions and generating
negative tax consequences). If an investor can time the market
correctly and consistently over time, that investor can make
a lot of money.
In reality, it is deceptively difficult
to know when a market is near its top. When the market nears
a top, investment outlooks are rosy, investors have been making
a killing, company profits are rolling in and the bookshelves
of your local bookstore are chock full of "get rich quick"
books featuring the latest investment fad (in 2000, it was
tech stocks, in the mid-2000's it was real estate and housing
stocks, etc.). And occasionally you will read an article buried
in the back of a financial publication about how some investment
guru has been calling for a bear market for the last three
years. You are thinking, "I'm glad I'm not that guy...he's
missed a great bull market."
But right about that time, the market heads
downward on one of its natural cycles and the guru who has
been calling for a bear market tells the press, "See?
I told you!" but neglects to tell you about all the great
gains he has missed by being out of the market.
On the flip side, it's also deceptively
difficult to know when a market is near its bottom. Investment
outlooks are gloomy, articles start popping up about how gold
is the the safest investment (even though it historically
has a return approximately equal to inflation and is extremely
volatile), and everyone thinks the economy will get much worse.
And your local bookstore's shelves are full of books touting
"How To Profit From the Coming Catastrophe."
The facts: studies show that when
people attempt to time the market with real investments, not
only are they usually wrong, they usually end up getting it
exactly wrong: putting more money into the markets at the
"top" (due to greed) and selling at the "bottom"
(due to fear).
To illustrate the point, here is a recent
article we wrote:
Market Timing Usually
Leads To Disaster
Want to boost your portfolio's
long-term profits by 41%? Then don't try to time the market.
That is the conclusion reached by
DALBAR Inc., a mutual fund research company. The firm compared
two scenarios over the last twenty years:
The end result? The investor who ignored
the ups and downs of the financial markets and consistently
invested a fixed amount into the stock market each month had
investment profits 41% higher than the investor who
tried to guess when the market was going to go up or down.
Why such a big difference? DALBAR states
that, "Investors are motivated by greed and fear – not
by sound investment practices. Close examination of investor
behavior reveals that as markets rise, investors pour cash
into mutual funds, and a selling frenzy begins after a decline.
Tracking the dollars going into and out of mutual funds over
a given month compared to market performance proves the correlation:
as markets rise, cash flows swell; as markets decline, cash
flows deflate."
Research by Russell Investments also found
that investors poured money into the stock market near market
tops and withdrew money near market bottoms. February of 2000
saw the largest-ever net inflows of money into stock mutual
funds. The very next month the stock market reached its peak
which was the start of one of the worst declines in history.
With perfectly awful timing, investors had once again incorrectly
guessed the direction of the market.
The same bear market bottomed
out in October 2002. Some of the largest outflows from the
stock market occurred in the few months preceding October,
meaning many investors were once again timing the market
in the very worst way.
The next time fear or greed
grips you when investing, think twice about giving into
your emotions when it comes to trying to time the market.
The odds are you will do much better consistently adding
to your investments regardless of the market outlook.
DALBAR's study concludes
with some wise words for investors, "Start early, keep
contributing and don’t panic."
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