I often get involved in discussion with clients
about whether it is "too late" to get into the market or conversely if it is
time to "pull out". Without calling it by name what they are really trying to
do is to time the market. In a perfect world we could accurately predict the
ups and downs of the market and adjust our investment exposure accordingly. It
feels like a reasonable thing to do because while we can’t always tell what an
individual stock will do, it seems pretty obvious when the market is going
down it’s time to sell and when the market is going up it’s time to buy. Or is
it? A recent study by Morningstar determined that while we may think we can
predict the future direction of the market, the fact is we’re pretty bad at
actually doing it.
Morningstar examined the actual cash flows, the
incidents of investors buying or cashing out of the funds, at a variety of
different types of funds. What they discovered was that pretty much
universally, most investors sold too early and bought too late resulting in
personal returns well below what they would have experienced if they had just
stayed in the fund. This was especially true for the most volatile funds where
investors were more inclined to try to time their exposure. Morningstar also
observed that less volatile funds offered fewer timing opportunities and were
more likely to be populated with buy and hold investors who did better in the
long run. No surprises there, buy and hold strategies in less volatile funds
tend to produce better returns in the long run.
Part of the problem with market timing of course is
that the decision to buy or sell is usually made once a trend is already well
established. For example, investors studying the markets today could easily
conclude that funds with substantial exposure to oil companies are a good bet
because the oil sector has posted very attractive returns and the increasing
demand for oil seems likely to continue for the foreseeable future. However,
the fact of the matter is that many analysts are predicting that the bulk, if
not all, the upward movement in oil prices is over. In the realm of reasonable
scenarios for these funds the best case scenario may be that they produce only
modest, positive returns. If oil prices actually soften, the returns on these
funds are more than likely to be negative. This is exactly what happened to
all the unfortunate investors who piled into technology stocks in 1999 on the
basis of the returns they saw in the sector in prior years.
It is frequently said that it is fear and greed
that really drives investors and market timing is all about fear and greed.
Unfortunately those same instincts tend to blind us to the common sense
approaches that more often than not produce better results. If you are
investing for the long term, market timing is not an approach that makes
sense, tempting as it may be.
As always, I welcome your questions and comments.
Randy Gridley
August, 2005
