Beating the Timing Temptation

As Liz Ann Sonders notes in the posting below, a lot of investors are now wondering whether it’s too late to jump into the market, or, for those who have been in the market during the rally, whether it’s time to cash out. As Sonders says, such all or nothing decisions are very dangerous — and The Stingy Investor’s Norm Rothery has laid out some excellent reasons why.

In an article titled “Tempting Temptation” (originally published earlier this summer in Canadian MoneySaver but still quite relevant now), Rothery touches on a number of studies and data sets on market timing — all of which show that trying to jump in and out of the market often leads to major underperformance.

“Even normally level-headed index investors suffer from poor timing,” Rothery writes. “ reports that the Vanguard Total Stock Market Index fund lost 1.59% annually during the 10 years ending April 30, 2009 but index fund investors suffered a 4.04% annual decline. In this case, poor timing reduced returns by 2.45 percentage points annually.”

“To be fair,” Rothery adds, “investors in some funds get it right and a few investors are quite good timers, overall. But the odds are stacked against the average investor. Most are likely to lose roughly 2 to 5 percentage points annually, over the long run, due to poor timing.”

Another example of this bad timing comes from an article Jason Zweig wrote for Money magazine, Rothery notes. Zweig examined how mutual fund investors fared during the Internet bubble’s rise and its bursting earlier this decade. “From 1998 through 2001 the average U.S. mutual fund earned 5.7% annually but the average mutual fund investor earned only 1.0% annually,” Rothery writes. “What happened? Funds posted phenomenal early performance figures and investors loaded up. The bubble burst and they fled. As a result, most fund investors didn’t get the good early returns and instead were left with the dross of the later period.”

“The majority of investors are poor market timers,” Rothery says. “After all, bubbles get going when everyone becomes infatuated with stocks. If folks stayed away then big bubbles wouldn’t get off the ground. Similarly, crashes occur when the crowd flees in panic. This boom and bust pattern is a fundamental feature of the markets and it has been so since time immemorial.”

Rothery offers a couple tips for how investors can avoid market timing temptation. Among them: Refrain from constantly checking your portfolio. He cites data that Nassim Taleb used in his book Fooled by Randomness. “Taleb considered the case of a smart investor who earns 15% annually with 10% volatility. That is, in any one year the investor has a 68% chance of earning between 5% and 25%, and a 95% chance of earning between -5% and 35%. He has about a 93% chance of posting a gain in any year. If he checks his performance once a year, he is likely to be happy to see a profit and unlikely to be hit with a loss.

“But if he looks at his portfolio more frequently then he’s much more likely to be in the red. His portfolio has a 77% chance of being up in any particular quarter and a 67% chance of being up in a month. If he checks each day, he only has a 54% chance of seeing a day-to-day gain and he’ll encounter bad news 46% of the time. Combine the near even odds of a profit or a loss with the knowledge that losses have twice the emotional impact of gains and you have a recipe for unhappiness.”

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