The Advice Remains the Same: Adventures in Market Timing

(Note: This item is part two of a series on why you shouldn't alter your investment strategy during booms or busts. For other posts in the series, see the links at the bottom of this item.)
My previous post discussed market efficiency. Now I want to address the fallacy of market timing and why information is not enough for making investment decisions.

As to trying to time the market, take a look at the historical evidence. If you are thinking about getting out until things are clear again, consider that the evidence on market timing is even worse than on stock selection. Mark Hulbert of the Hulbert Financial Digest says his data backs up his 80/20 rule: 80 percent of market timers fail over any reasonable period of time. I don't like those odds. Neither should you.

One reason that market timing fails is that so much of the market's return occurs during very brief and unpredictable periods. Another reason is that you have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. If you go to cash, you may be "whipsawed." You risk getting out after a severe drop, missing a big rally and jumping back in only to experience another severe loss. You would end up worse than if you had simply stayed the course. That is why I believe going to cash is not a winning strategy.

The difference between information and wisdom
Information can be defined as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess -- above market -- profits. When I ask investors why they are so willing to abandon their well-designed plan, they say something like: "Isn't it obvious that the situation is terrible?" The question they fail to ask is this: If it is in fact obvious, isn't the bad news already built into prices? After all, that is why prices have already gone down.

They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?

If you feel the need to sell, consider that there is a "universe of risk." Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.

In my next post, I will conclude by talking about the lack of success of defensive strategies employed by some to ride out the investing roller-coaster.

Follow the series "The Advice Remains the Same":

• Part one: Markets are Efficient
• Part two: Adventures in Market Timing
• Part three: Defensive Strategies Won't Protect You