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.

Will this stock be your next multibagger?
Give me five minutes and I'll show how you could own the best stock for 2014. Every year, The Motley Fool's chief investment officer hand-picks 1 stock with outstanding potential. But it's not just any run-of-the-mill company. It's a stock perfectly positioned to cash in on one of the upcoming year's most lucrative trends. Last year his pick skyrocketed 134%. And previous top picks have gained upwards of 908%, 1,252% and 1,303% over the subsequent years! Believe me, you don't want to miss what could be his biggest winner yet! Just click here to download your free copy of "The Motley Fool's Top Stock for 2014" today.

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.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers