Jumping into today’s stock market may be appealing to those whose view tends more towards a “glass half full” than “half empty.” Sharp declines like the ones experienced in March elicit a variety of responses. Some see the opportunity for a 20% gain with the economy re-opening and return to the February peak, while others fear a second wave of infections and want to sell shares to avoid further pain or loss.
This article explores the temptation we have to try to time the stock market and why it should be avoided. It concludes with a suggestion for those who feel they need to try.
An average can be misleading
The price of a stock is the meeting point of sellers and buyers. It does not imply that the current price is correct, simply that across all participants in the market, it is a fair price at that point in time. It is equally likely that it will go up or down from here. The novel coronavirus created a novel economic environment that makes pricing stocks difficult.
Never has the majority of the world’s population been told to stop work and stay at home for weeks, if not months. Without a reliable precedent, it is understandable that the range of economic outcomes is wider than usual, from very negative to positive. The current value of all stocks is simply the average of all these scenarios. Over time, the range will narrow, indicating a greater confidence in long-term rather than short-term stock market returns.
Our first article on the virus was published on February 24, the first day of significant stock market decline this year. Re-reading it reminds us how few experts identified the extent of the economic impact at that time. Many focused on the global supply chain, but not worldwide stay-in-place orders. The same is true today as no one knows how consumers will react as states loosen restrictions. While there is confidence that the stock market will be higher in the long term, the short term is unknowable.
“Skate to where the puck is going” – Wayne Gretzky
Our firm believes in the science of investing, not in guessing the near-term fluctuations of financial markets. Having a long-term asset allocation target grounded on our personal goals avoids the danger of trying to “get in or out” based on daily, weekly, or monthly market fluctuations. Once you know how much stock market exposure to target, a plan can be developed to get there. You may choose to move directly to your target level of stocks or a more gradual strategy of small moves over six to nine months might feel better. The key is to get to your target.
Avoid these five temptations to time big moves into or out of the stock market:
1) See Patterns in Random Events
Our ability to find patterns has helped us survive as a species. Ancient Egyptians documented the level of the Nile day by day for a thousand years to help predict floods and droughts. Sometimes we come to the wrong conclusion when looking at patterns: seeing the sun rise in the east and set in the west led us to initially conclude that the sun rotates around the earth.
Sometimes we even see patterns in random data, which is called “apophenia.” For example, if in our experience stocks moved up when certain factors were present, we will want to buy each time we see the same factors emerge.
2) “Remembering” Altered Circumstances
Research has shown that we don’t store memories in the same way a computer’s hard drive stores data. We tend to remember stories better than facts, and each time we retrieve the story from our memory, it evolves. A highly regarded reporter returning from a war zone told of his helicopter coming under fire. It was a vivid memory which he repeated on a number of occasions, convinced it had happened to him. It had not.
Given his well-established standing in the profession, no one accused him of lying. His memory had changed with time. He told the story as he remembered it, not as it happened. The next time you hear a story about the size of the fish a friend caught or how they successfully timed the stock market, appreciate that they may be telling it as they remember it, but not as it happened!
Sometimes the opposite occurs. We remember wanting to take action, not taking it, and then regretting our inaction when it turns out to have been desirable. I used to tell of the opportunity I had to buy a vacation condo in a very desirable location. The condo ended up massively appreciating. It is an “if only I had…” type of story. I now realize that I may not be remembering all the facts, just those which make the story interesting.
3) Predict the Future Based on Too Limited Information
Who is the greatest Major League batter of all time, Ty Cobb or John Paciorek? Based on their career batting averages, it is Paciorek at 1.000, not Cobb with .367. One reason Ty Cobb is in the Hall of Fame and John Paciorek is not is that Cobb came up to bat 11,430 times while Paciorek had three at-bats in the only game he played in the Major League1. There are statistical measures that determine the number of observations required to differentiate luck from skill. Thirty is a minimum, more always improves accuracy.
4) Find Facts that Support Our View
Two people with the same information may well come to different conclusions. Behavioral economists call this confirmation bias: we focus on what supports our hypothesis and discount the rest. Our blog on how democrats and republicans view the same economy differently provides an example of confirmation bias.
5) Believe Our Insights are Unique
Stock prices adjust rapidly to new information, which is one reason why it is hard to outsmart the market. Not only does an insight have to be right, but you also need to trade on it before others see it. Ask yourself, “Why do others not see what I see?” and “Why is the information I have not available to others?” since once the information is disseminated, the potential for exceptional gains dissipates.
A suggestion for those who feel they must try to time markets
We often do things that are not good for us. Some people smoke despite the warning on the label while others eat and drink in excess. With investing, we desire the over-sized returns from successful timing in entering and exiting the stock market, despite the research that it is unlikely to add value.
If you feel the need to experiment with market timing, we recommend you do it with a small portion of your wealth. Create a separate account with no more than 10% of your financial assets. Set a target level of stocks, trade in and out of broad-market funds, and keep a record of, rather than try to remember, your results over time. Make an honest assessment of your success or failure. The experiment may or may not end up adding value, but you will not endanger achieving your long-term financial goals.
1 Source: “The Perfect Game” by Ted Keith, Sports Illustrated July 9, 2012