Trying to Time the Market is a Fool's Errand

There is a reason that trying to time market bottoms and tops are what most would call a ‘fool’s errand’, and this is mostly because market bottoms and tops are exclusively obvious in hindsight, but also because it goes against our basic human nature. When the markets are declining day after day, and there is seemingly no end in sight, our instincts are to assume that this trend will continue and fear that the markets will not recover for quite some time. On the contrary, when markets are rising day after day, it is easy to believe that this trend will continue and human emotions stoke a fear that selling at those levels would be ‘too early’. Calling the winter market top of 2021 is now obvious in hindsight – inflation was picking up and the Fed was preparing for higher rates and reduced liquidity, but yet most investors chose not to sell – why? We believe that it is because most investors believed that the markets would continue their climb higher, as was the case in the latter part of 2020 and throughout 2021. Investors’ fear of selling at that point and regretting selling too early was high. 

Regret Aversion

The fear of buying too high when the markets are plummeting and selling too early when the markets are reason can both be attributed to what is called the regret aversion bias. When markets are rising, investors may become hesitant to sell some of their positions out of fear of regretting this decision later on, in the event that markets continue to rise. Conversely, when the markets are declining, as they are in today’s markets, investors can have a fear of buying too soon and regretting not purchasing at a lower price point. While both forms of regret (not selling at the highs and not buying at the lows) can be painful for an investor, there is a common belief that higher emotions are associated with financial loss than financial gains. To demonstrate this, a behavioural finance study concluded that investors prefer to avoid a loss more than acquiring an equivalent gain. The study used the example that when given the choice of receiving $900 or taking a 90% chance of gaining $1,000 (a 10% chance of gaining nothing), most investors would opt out of risking the higher gain of $1,000 and would take the guaranteed $900. Both outcomes are virtually the same ($900 vs. 90% X $1,000 = $900). On the other hand, when those same people were given the choice between losing $900 or taking a 90% chance of losing $1,000, most investors opted to take the 90% risk and attempt to avoid the loss. 

Comfort and Returns

‘Comfort is the enemy of returns as you can have comfort, or returns, not both’ – Mark Yusko

Behaviourally, investors’ willingness to sell stocks increases as the market declines, as it becomes more uncomfortable to hold on to a losing position. In order to feel more comfortable, those investors will sell the declining positions in order to ‘stop the bleeding’. In some instances, selling a losing stock is certainly warranted, where the fundamentals have changed or it is going against the market, but in other instances, it can simply be attributed to systemic selling across the broader markets. The same principle applies to buying at the very lows, it can be uncomfortable buying a stock after it has declined significantly (such as what we are seeing across many stocks today), but historically these periods have represented some of the best long-term buying opportunities.

Of course, the principles of ‘buying low and selling high’ and ‘buying when others are fearful and selling when others are greedy’ are well-known mottos to most investors, yet in practice, these are much harder to execute on than in theory. Almost every investor would prefer to buy at the exact bottom of the market or sell at the exact top so that they do not have to hold through the uncomfortable waiting periods in between, but part of a long-term investment strategy involves holding through both bull and bear markets. Many studies have shown that missing out on the few best stock market days of the year can be detrimental to an investor’s portfolio, and while holding on during bear markets may be uncomfortable at times, it is in the depths of the bear markets where bull markets are born. 

Research for Today, Invest for Tomorrow.