3 Reasons Why Market Timing Doesn't Work

Why trying to time the market is a fool's endeavor.

May 28, 2014 at 9:31AM

To time or not to time -- that is the question.

For almost everyone, it's obvious what the answer should be.

Study after study shows that trying to time the market is detrimental to one's financial health. According to financial research firm DALBAR, the average U.S. stock market fund investor realized an average annual return of 3.7% per year versus the S&P 500's 11.1% over the past 30 years. A $1,000 investment in the S&P made 30 years ago would be worth $23,583 today, while the average investor would have an ending balance of just $2,965. 

Bad timing has something to do with this underperformance. Too many people try to buy low and sell high yet end up doing the opposite. While timing might make sense in theory, here are three reasons why it doesn't work.

Irrational markets
First, markets aren't rational all the time: Expensive stocks can become more expensive, while cheap stocks can become more cheap. In bull markets, people buy stocks simply because they're going up, while in bear markets people sell stocks because they're going down. This type of momentum investing often causes stock prices to dissociate from their underlying fundamentals for significant periods of time. 

While many investors think those dissociated stocks will eventually revert back to their original price levels, this actually doesn't happen as frequently as it should. When a company's stock becomes more expensive, the company has a better chance of success because it can raise more capital at higher prices. The inverse is also true. When a company's stock tanks, the company has a lower probability of success because it won't won't be able to raise as much capital. The change in price causes a change in fundamentals, thus making the past valuation metrics used by market timers less meaningful. 

Plug Power (NASDAQ:PLUG) is an example of this phenomenon. Plug Power's management has overpromised and underdelivered on guidance for many years. Because of management's spotty execution record, along with the company's nosebleed valuation metrics, many investors sold short around $3-$5, thinking prices could not get any higher. Plug Power ended up soaring irrationally all the way to $11.72 before the bubble burst. This no doubt caused many market timers some pain.

Now that the bubble has burst, the stock is unlikely to sink back to the levels whence it came (below $1), because the company raised $124.3 million by issuing 22.6 million shares for $5.50 each. The company's high price allowed the company to do a secondary offering, which in turn gave Plug Power more runway space to turn a profit. If management uses that capital wisely and takes advantage of growth opportunities, the company could eventually grow into its valuation. Whether that potential will be realized is a different question.

Black swan events
Second, black swan events happen more frequently than people expect.

Black swan events are basically unpredictable events that most investors don't see coming. They include natural disasters, coordinated central-bank interventions, and other events that affect the broader economy. Most market timers don't factor black swan events into their calculations because they don't expect them to occur. When they do occur, black swan events often catch market timers off guard and cause lower returns.  

One example of this phenomenon is the Lehman Brothers bankruptcy of 2008. Most market timers assumed that the U.S. government would bail out Lehman Brothers because of the bank's systemic importance. Because of this expectation, many market timers were more long than they otherwise would have been. When the government let Lehman Brothers declare Chapter 11 bankruptcy instead, many market timers were caught off guard and took significant losses in the ensuing sell-off. 

Missing the big winners
Third, market timers often miss the big winners. Many of those winners will trade at high valuations that don't make any sense. Because they don't make any sense, market timers will sell those stocks and miss the remaining rally, which could continue for years.

Tesla Motors (NASDAQ:TSLA) is one example of this. After shares rallied 50% to 100% from the $35 base, many market timers thought the stock had peaked, and they sold. They understandably thought the electric-car producer could not compete against the likes of Toyota or GM because it lacked the big auto companies' resources.

Thanks to that logic, those timers missed the subsequent move up to $200-plus today. 

The market timers missed out on the move because Tesla Motors' shares are valued based more on perception than on fundamentals. If enough people perceive that the company will revolutionize the automotive market, Tesla's stock will automatically go higher. With the stock higher, Tesla can raise capital, receive free publicity, build new factories, and earn more money, which in turn causes Tesla's stock to rise even higher. This cycle can feed on itself for years. When the cycle does end, if management does its job correctly, the underlying fundamentals of Tesla could already justify the stock price.

The bottom line
The combination of irrational markets, black swan events, and missed multibagger opportunities make the task of beating the market nearly impossible. Many investors who try to beat the market actually lower their own returns. For most investors, the best approach to investing is to accept normal market returns, buy a basket of high-quality, non-correlated stocks or an index fund and simply hold for the long term.

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Jay Yao has no position in any stocks mentioned. The Motley Fool recommends General Motors and Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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