Why you stink at market timing

By Investing Basics Consumer Reports

Occasionally, we have to speak the hard truth to our readers. It can be painful and awkward, just as it is when you have to tell a friend that he’s a terrible dancer or that his favorite jacket is kind of ridiculous-­looking. But here goes:

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You stink at timing the market.

Please don’t take offense, and please understand that we include ourselves in the accusation. The fact is that there is overwhelming evidence that ordinary investors who trade in and out of the market with the hope of being able to accurately predict its movements are exceedingly poor at it, and as a result, significantly harm their returns. And the more often you do it, the worse off you are. Evidence shows that the returns of frequent traders are subpar even before you factor in all of the trading costs they incur.

But don’t just take our word for it. Consider:

  • The American Association of Individual Investors regularly surveys its members to determine what percentage feel bullish, bearish, or meh about stocks. If those individual investors—generally do-­it-­yourselfers who pick their own stocks and mutual funds—are collectively pessimistic, it’s considered a “buy” signal among certain market-watching cognoscenti. If the AAII members are really bullish on stocks, those same market mavens see it as a cause for concern.

    The reason? AAII members seem to have an uncanny ability to be exactly wrong, especially when they’re extremely bullish or bearish.

    As of May 2014, according to the AAII survey, individual investors were neither especially bearish nor bullish, even as the broader U.S. stock market had almost tripled since 2009. Their current sentiment is a far cry from how they felt in 2007, when most individual investors were still, incorrectly, optimistic about stocks.
  • And ordinary investors all too often act on those infelicitous sentiments when they buy and sell stock funds. (Funds are still the primary investment vehicle for ordinary investors.) Research usually shows that when new money is rapidly flowing into stock mutual funds, future returns will be lower than average. And when money flows out, stocks outperform. Even though stocks have gone up in price since 2009, for the most part individual investors have been keeping their money out of equity funds, according to data from the Investment Company Institute, a trade association of the mutual-fund industry. Based on that piece of evidence, the current bull market for stocks, going strong for five years now, might still have more room to run.

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  • Also, the financial industry analyst firm Dalbar, has been monitoring the returns of the individual investor for 20 years. Its annual Quantitative Analysis of Investor Behavior report has repeatedly shown a vast underperformance. The average annual return of the Standard & Poor’s 500 Index over the past 20 years through the end of 2013 was about 9.2 percent. But according to Dalbar, ordinary individual investors managed to earn only 5 percent annually in their stock fund investments. Dalbar has found that, as a whole, individual investors withdraw funds when the market is down and add to positions at high points—the exact opposite of the buy-low, sell-high maxim.

Dalbar theorizes that more recent events in the stock market are what inform an investor’s expectations the most. It’s what behavioral scientists call the “recency effect.” One’s most recent experiences (in this case, stock-market performance) disproportionately influences one’s perceptions and expectations, and ultimately one’s actions.

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For example, in 2002, after 20 years of a secular bull market in stocks, half of Vanguard’s 401(k) investors expected stocks to return 14 percent or more over the next 10 to 20 years, well above the long-term performance of 10 percent annually. And many investors in 2009 expected stocks to decline further. The once-in-a-generation decline of stocks in 2008 (they lost 37 percent that year) cast a long shadow. Accordingly, money continued to flow out of stock funds and continues to do so more than five years later.

To show how the impulse to time the market can work against you and how a more even-tempered approach could be financially rewarding, we assembled three “investors.” In the scenario we set up, they could invest their savings in either certificates of deposit or arguably the hottest stock fund of its day—Fidelity Magellan in the 1980s and 1990s, the tech-oriented Janus fund in 2000, and the plain-jane Vanguard 500 Index fund in 2007. Over their investing careers, from 1983 through 2013, they all max out their IRA contributions, for a total contribution over 30 years of a little more than $88,000.

Two of them are market timers; the third is not. We put them through those paces not because we recommend an asset allocation of all stock funds or all CDs (we don’t) but to make some points.

The market timers have the uncanny ability to invest all of their accumulated CD savings in the stock market exactly as it peaks. But there’s a difference. Once singed, one retreats into the safety of CDs a year later, only to lurch back into the market again, at exactly the wrong time. (He just can’t help himself. ) Despite his unfortunate timing, the other investor holds on to his funds, perhaps reluctant to sell his “losers.” Here are the highlights (or lowlights):

1987: Fidelity’s Magellan fund has seen better days, and those days were in the 1980s, when the legendary fund manager, Peter Lynch, was it its helm. But of course even Magellan couldn’t steer entirely clear of the stock market crash of October 1987, when stocks lost 22 percent in one horrific day. Although they had fully recovered by 1989, 12 months after the crash, Magellan was still down 15 percent.

2000: No mutual-fund family was more associated with the tech wreck than Janus. Its flagship, the Janus fund, with more than $22 billion in assets in 2000, was one of the largest funds of its day and owned tech stocks such as America Online, Cisco, and Microsoft. Twelve months after the March 2000 peak, investors in the Janus fund had lost 37 percent. Stubborn investors would have to hold the fund not two years or even 12, but 14 years to get back their original investment.

2007: Index funds had finally reached prime time, and the index-fund archetype, the Vanguard 500, had become the world’s largest mutual fund. The financial crisis that began that year dragged down all stocks, but large-cap stocks fell the most, losing 23 percent in the 12 months ending in October 2008—more than small- and mid-cap stocks. There was still more pain to endure; it would take an additional four years for the index-fund investors to fully recover.

As you can see from the chart below, the returns of the three investors are significantly different. The investor who cut his losses after each year of misery, despite the accumulated interest from short-term CDs, has $5,000 of losses to show for his diligent savings.

But the saver who bought at the top, then stubbornly held on to his investments despite his terrible timing, didn’t fare as poorly. At the end of 2013, his investments—the $156,000 still invested in the three mutual funds, and $31,000 in a six-month CD (ready to deploy the next time the market peaks)—had more than doubled the $88,000 in contributions. But over 30 years, that $187,000 results in a gain of only $100,000. His rate of return (sometimes referred to as personal rate of return, it weighs each dollar invested by how long it has been invested) is only 5.6 percent annually. And much of that was because of higher CD rates in the earlier part of his investing career.

Our third investor still invested in those widely sold funds but wasn’t cursed with the timing problem at all. Instead, the savings went directly into the funds. The $33,000 he drove into Fidelity Magellan from 1983 through 2000 is now worth $264,000. About $32,000 more of his contributions were used to purchase the Vanguard 500 Index fund, which after six years grew to $52,000. Even the $22,000 he invested in the Janus fund from 2000 through 2007 is now worth more than $38,000. His total pot: $354,000.

Again, we’re not advocating an all-stock portfolio. If we have any advice for our successful long-term investor, it would be to diversify by using a portion of his stock holdings to purchase a total-market bond fund. As for the other two investors, they would benefit from starting over with a part-stock, part-bond portfolio. But first they have to unlearn some old habits. —Chris Horymski

Bad timing can cost you

Most investors are invariably wrong-footed when trying to time the market. Buying at market tops—in recent history, 1987, 2000, and 2007—results in returns well below those of dollar-cost-averaging investors.

This article originally appeared in the July 2014 issue of Consumer Reports Money Adviser.

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