[Editor's Note: Today's guest post was submitted by Matt Elliott, CFP®, CSLP® of Pulse Financial Planning. Pulse is a fee-only fiduciary and one of our WCI Recommended Financial Advisors. I'm still puzzled when I see members of our WCI community actively trying to time market lows or buy out of favor individual stocks (think cruise lines) for the classic reasons discussed below. I'll see if Matt can convince you today that this is a losing strategy.]
As a financial planner, by far the most common questions I get are:
- My investments are down, should I get out of the market?
- Stocks are down recently, is now a good opportunity to get into the market?
- I heard XYZ is going to be a hot stock, should I buy it?
- I heard XYZ event may cause a downturn in the stock market, should I sell now?
These questions ramp up during times of market volatility when investors are looking to buy stocks “on sale” or avoid further losses in their portfolio.
However, this is really just the same question asked in different ways though, which is:
Should I attempt to time the stock market?
I’ll be up front here: No, you shouldn’t try to time the market. I’ll explain why through the 4 questions that inevitably follow when I explain this.
#1 Why should I not try to time the market?
Reason 1: It is incredibly difficult to do consistently over the long term.
Time and time again, studies show that professionally actively managed portfolios do worse than a diversified buy and hold strategy. To make matters worse, actively managed portfolios have higher costs, which only exacerbates the underperformance as was shown in this report from the Center for Retirement Research at Boston College.
Remember that these are experts that are unable to beat market returns by attempting to time the stock market. If you are an individual investor without a background in finance and powerful technology at your disposal, you are at an even further disadvantage. I can attest first-hand that I’ve seen hundreds of individual investors attempt to do this over the years, and I’ve never seen it go well in the long run.
Reason 2: It costs more.
Depending on what you are trading, and where, you may run into transaction costs each time you make a change. If you are using ETFs, you also have to deal with the “spread” (difference between the bid and ask price) each time you buy and sell. That liquidity cost can add up in the long run, particularly on larger trades. If you are using mutual funds, many have additional short-term redemption fees you will be charged if you don’t hold onto the fund long enough.
Reason 3: It is not tax efficient.
In a taxable account, you will have short term holdings, which are taxed at a higher rate than anything held longer than a year. Tax brackets change year to year, but most Americans pay 15% in long-term capital gains taxes. This number can be as high as 20% for high-income households, but also can be as low as 0% if your income is below a certain threshold. Short-term capital gains are taxed at your ordinary income rate – which is always going to be higher than the flat long-term capital gains rates.
Actively managing your portfolio also makes taking advantage of other tax planning strategies such as tax-loss harvesting more difficult. When you’re trading based on speculation of where investments will go in the future, you may be unable to trade based on what you know would be good for your tax bill next year if the two strategies differ. This adds unnecessary complexity to your portfolio.
You will also have to pay tax on your gains as soon as you sell the investment, rather than being able to take advantage of deferring your tax bill into the future. In fact, you may never have to pay taxes at all on your investment gains if they pass to your beneficiaries or you donate the appreciated shares to charity in the future.
Reason 4: It takes more time and creates more stress.
I don’t know about you, but I’d rather spend my time on other things than reading Yahoo Finance articles at 2 am. That might be a worthwhile activity if it worked, but we already discussed that studies consistently demonstrate that you are more likely to make a poor investment than a good one by attempting to predict future stock prices.
We have so many decisions as it is, complicated trading strategies that are unlikely to work only add stress to our already hectic lives. When you try to time the stock market, you actually have to be right twice for it to pay off. You have to be right about the time to buy, and then again when you sell.
One example of this that stands out in my mind is an old client that got out of the stock market just as things started to turn south during the 2008 financial crisis. That could have turned out to be a very fortunate decision, however they never got back into the market. Every time I spoke with the person over the years, the answer was the same – “I just think the market is going to take another dive then I’ll jump back in”. I can’t imagine how painful it was each time they saw the stock market hitting all-time highs for the next ten years, yet felt handcuffed by all of the gains they already missed out on. The result was a decade of missed opportunity, and a far worse result than had they weathered the storm and stuck to an investing plan in the first place.
#2 If timing the stock market weren’t possible, why was my neighbor (or friend, in-law, CNBC talking head, etc.) able to do it?
I don’t think humans will ever stop using anti-aging creams, weight loss pills, or stop gambling. It’s in our nature to seek shortcuts. Doing things the right way can be hard, boring, require discipline and take time. That doesn’t mean you should buy a lottery ticket and diet pills as the solution to your health and money problems.
One reason people continue to try to time the stock market is due to overconfidence (or optimism) bias. In an episode of “100 Humans” on Netflix recently, panelists asked a group of 100 people to raise their hand if they think they are smarter than the average human in the group. 80 people raised their hands (God bless the hearts of the 20 that didn’t).
We know only 50 of the people can really be “above average”. What is happening here is a classic example of overconfidence bias – we think our ability is higher than it actually is. The same bias exists with our own belief of our driving ability, athleticism, and yes – our investing. This can lead to investing too much in risky investments which we know little about without even realizing it.
#3 I think I’m right in this case anyway, why not trust my gut?
The problem is that the less we know about something, the more confident we tend to be in our ability. This is known as the Dunning-Kruger effect, and I’ve seen people with little investing knowledge devastate their own financial futures by attempting to pick individual stocks (or bitcoin, options, futures, etc.) or time when to buy and sell the stock market.
If you are set on investing in individual stock picks or trying an active trading strategy, I recommend keeping this to less than 5% of your investable assets. That way you can scratch that itch and ensure that you’re not blowing up your financial future in the process. I call this a core (95% of investments in a diversified, disciplined plan) and explore (5% of investments in your individual picks) strategy.
Investing should be boring. It should take a long time. If you’re looking to your investments as a source of entertainment, I’d suggest a less expensive hobby. (Maybe pick up golf?)
#4 So what should we do with our investments then?
The first question to ask yourself is, should this money really be invested in the first place? Before investing you should:
- Make sure you have at least 3-6 months of expenses in your bank account. If you are in a job that is susceptible to recessions or your income is not stable, this number should be 6-12 months.
- Make sure you don’t plan to use this money for any short term goals such as a down payment or vacation within the next 5 years.
Once you know how much you have available to invest for the long term, you should create your investment strategy based on:
- Your time horizon (how long until you will use the money)
- Your risk tolerance (how much volatility can you handle in your investments)
- Your risk capacity (how much risk do you need to take to reach your goals)
- Consider your situation for the best account to invest in – a Roth IRA, your employer 401k through higher payroll deductions, a trust, or a taxable account.
- Diversify your investments across different asset classes based on your investment strategy.
- Rebalance your investments regularly to keep them on track. This builds in a disciplined, buy low, sell high process and ensures your investments don’t become too aggressive or too conservative over time.
The good news is, you don’t have to spend your energy worrying about when is the perfect time to buy and sell. You can simply set up a sustainable, disciplined plan. By sticking to it, you will be far better off than your neighbor (or co-worker, in-law or CNBC talking head).
What do you think? Are you trying to time the market or buy individual stocks (or did you in the past)? How has it worked out for you? Comment below!