The downsides of timing the market
For Vikram Singh (name changed), a finance professional, his portfolio performance over the last few years was a source of pride. Singh had a predilection for predicting market movements and tinkering with his investments accordingly. He doesn’t remember instances before the coronavirus pandemic where his analysis resulted in him having to spend sleepless nights because of colossal losses.
However, Singh recalls that the winning streak was dented when the pandemic broke out last year and the crash in the global markets served as a clarion call for him. He narrates, “The bloodbath that happened in the markets across the globe wielded heavy blows to my portfolio and that made me realise that no amount of expertise can help anyone in timing markets correctly every time.”
For many investors, the idea of entering and exiting investment classes or shifting asset allocations in their portfolio by crystal gazing market movements is a common wealth management strategy. Markets move in cycles and while there are strong indicators of the subsequent phases that markets may enter into at any given point in time, it is impossible for any investor to accurately and consistently predict trends.
What is market timing?
Market timing refers to predictions made by investors about price movement. A simple example of that would be when an investor thinks a stock price will climb or fall in a particular time span (usually in the ultra short time frame) and decides to buy or sell it based on that prediction. Multiple ideas or events can trigger these sentiments, such as major geopolitical developments or investors simply tracking historical price charts or trying to decode patterns of stock price changes when companies declare their earnings. Investors can apply market timing fundamentals on all kinds of securities that are impacted by market forces.
Successful market timing entails two kinds of decision making: when to enter and when to exit the market. The guessing game has to be right on both counts because being wrong once means getting out at the incorrect time or not being able to get back at the opportune time. If one of these instances throws up unexpected results, the losses may be potent enough to scar your financial health. And if the spate of misfortunes continues, and your predictions turn out to be incorrect on multiple counts, your financial goals can be completely thrown off gear.
The pitfalls of market timing
It is commonly believed that portfolio managers and experienced investors have the capability to understand how markets work and hence are in a fairly strong position to predict its movements. But that is not true because irrespective of their knowledge and experience levels, volatility in investment markets is something no one has or will ever be able to foresee with foolproof accuracy persistently. Markets trends are driven by a vast labyrinth of factors and for predictions to be accurate one has to ace predictions for a series of happenstances, all of which could be unpredictable at a given point of time. So, investors who have been able to reap benefits through the market timing strategy, have simply had a lucky run.
There are ample studies that indicate the flaws of adopting an approach that relies on timing the market and it has been rejected by various experts around the globe. In 1975, Nobel laureate William Sharpe developed a framework for evaluating the potential of market timing in his publication ‘Likely Gains from Market Timing’. The objective of his study was to determine the requisite probability of correctly predicting market movements to make market timing count as a beneficial strategy. Sharpe found that a market timer who switches between 100% stocks and 100% T-bills on an annual basis must be correct about 74% of the time (on average) to beat the market. It is obvious that 74% is a tall ask for even the most experienced investors who have the acumen to anticipate market events.
Singh recalls, “Last year, when coronavrius cases were reported in India, I had not envisaged that it would spiral into one of the biggest humanitarian crises the country has ever seen and also trigger an economic downturn of a colossal magnitude. I don’t think any market maverick could have foreseen a pandemic and the extent of the disruption it brought along. This was a lesson in the futility of trying to predict market movements.”
The proclivity to time the market is also rooted in emotional responses such as fear and greed to market volatility. Since 1984, financial services market research firm Dalbar Inc. has published its annual Quantitative Analysis of Investor Behavior report, or QAIB. In its 2020 QAIB report, Dalbar concluded that fund investors who remained patient and didn’t focus on short-term market fluctuations were more successful than those who are more prone to responding emotionally to volatility for building wealth.
Buy-and-hold strategies in which investors select securities based on their goals and risk appetites are better suited for the long run. Regularly timed investments irrespective of market conditions afford you the benefit of rupee cost averaging through which you can buy assets at a variety of price points and the the impact of the episodes where the markets are hitting troughs gets ironed out in the long run. Periodically balancing your portfolio and ensuring the right degree of diversification ensures that the your portfolio’s risk is not too concentrated and should there be a market downswing, you would be better prepared to ride it rather than having to decide a right time for acting on your investments.
• Never underestimate the importance of formulating an all-encompassing financial investing strategy. It is futile to plan investments based on market timings. You need to be prepared for dealing with exigencies. If you have a more holistic investing strategy, the temptation to respond to anticipated market changes will be easier to tackle.
• Mutual funds offer the best solution because your funds will be actively managed by professionals (fund managers), who have vast expertise in investment management and you would not have to bother about timing.
• A buy-and-hold strategy works better than market timing because in the long run, the dents and bumps caused by short-term volatility eventually get smoothened.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.