Why Market Timing Is a Joke

I get tired of this same old "buy and hold" advice. In every secular bear market, folks who "stayed the course" generally made very little or no money. Instead, if they'd followed trends and got out of the market when it was crashing and bought back in at some point near the bottom, they'd have increased their wealth substantially.

This heavily edited comment is similar to many we receive at the Fool. I see more of these any time the market's down, as it has been recently. Let me point out why this type of thinking is not only wrong but dangerous. Plus, I'll tell you about what is perhaps the most overlooked factor keeping you from achieving great long-term performance.

What is "buy and hold"?
First, let's define some terms so we're all talking about the same thing. Most of us at the Fool advocate buying a stock with the intention of holding for the long term. We do not advocate buying, forgetting, and never monitoring your investment (though there is some illustrative power in that; see below). We may decide to sell for any number of reasons, including valuation or a change in the original investing thesis -- all of which are different from market timing.

I define market timing the same as my commenter above: The ability to call tops and bottoms and sell and buy all of our stocks accordingly. I do not mean to imply that we can't reasonably say when the market as a whole seems undervalued or richly valued -- but as we know, the market can continue to go down (or up!) a lot longer than common sense would dictate.

With that out of the way, here's why "buy to hold" investing works, and market timing doesn't.

Trade more, be poor
Studies have shown a direct correlation between the amount of trading and portfolio performance, and not in a good way. Brad Barber and Terrance Odean have published at least two studies on this subject, concluding that "trading is hazardous to your wealth."

Studies are one thing, but direct observational experience is another. Everyone can name several great buy-and-hold investors, such as Warren Buffett, Peter Lynch, Ben Graham, and Philip Fisher. None of these folks made their fortune by predicting market tops and bottoms; rather, they found great companies at fair prices and held most of them for a long time.

Our own David and Tom Gardner are another example of verifiable, on-the-record success. This coming March will mark the 10th anniversary of Motley Fool Stock Advisor, and the brothers have averaged 90+% returns for their monthly stock recommendations. Equal amounts placed in the S&P 500 over that time would have averaged 10.8%.

Now, let me ask you, who are history's great market timers?

Coming up with just a few names wouldn't be enough to stack against the list of buy-and-hold investors, but at least we could consider the possibility that market timing was viable for some people. Problem is, I'll bet you can't come up with one. Single. Name.

Sure, there have been people who've made great timing calls; with dozens of bull and bear "experts" constantly cacophonying on CNBC and the like, there are folks who are bound to get some calls right. But they can't do it consistently.

Even a simpleton
Again, while I don't advocate buy-and-forget investing, I wanted to bring up a great example of the power of buying and holding great companies. In July of 1995, Tom Gardner was inspired by a TV ad from a big financial firm, preaching that the individual investor just didn't have what it took to manage his own money. Tom wrote: "I decided to string together a portfolio of 10 stocks online that I believed could be held as a group for 10 years and expected to generate excellent returns."

Here are those 10 stocks, which he dubbed the Simpleton Portfolio, along with returns to-date:

Returns provided by Yahoo! Finance and author's calculations.
1-Estimated returns including Time Warner merger and spinoff.
2-Estimated returns including acquisition by Oracle.
3-Silicon Graphics (then SGI) filed for bankruptcy in 2009.

First, let me come right out and say that all of these companies are still well off their all-time highs, achieved at the height of the tech bubble that popped in 2000. Still, a lot about what you need to know about investing is encapsulated in this one remarkable table. Tom began this Simpleton Portfolio with about five years to go in a great bull market, which was followed by the great aforementioned crash of 2000. Since then, of course, we had a modest rise in the market, followed by yet another crash, the Great Recession, fear and loathing in Europe, Lady Gaga, and the debt-ceiling debacle.

This portfolio reflects bankruptcies, mergers, spinoffs, and several market cycles. It also reflects the awesome power of finding and investing in a portfolio of dominant and innovative companies. Some won't work out, of course, and some will spectacularly.

One secret ingredient
And now the most important part of this article, that most-overlooked factor in achieving great returns I mentioned earlier. It is this: The simple step of adding new money to the market on a regular basis. If you aren't doing this, you're cutting yourself off at the knees.

For example, from the date Stock Advisor launched until now, the S&P 500 is almost exactly where it was nine-and-a-half years ago. And yet, as I mentioned above, those who invested monthly -- through the ups and downs of a very tumultuous period -- would have an average return of 10.8% for each of those monthly positions!

Another example is the oft-quoted tidbit that it took 25 years for investors to break even during the Great Depression. On Sept. 3, 1929, the Dow Jones Industrial Average hit 381 -- and it did not reach that level again until November 1954. But as Jeremy Siegel pointed out in his book The Future for Investors, those who did little more than reinvest their dividends during that period actually showed an annual rate of return of more than 6% during that 25-year stretch!

Start now
If you're able to add new money to the market regularly, you'll be buying more shares when stocks are low, and fewer shares when prices are high. You can keep a long-term perspective, and not worry about trying to time the market, and more than likely being left behind when major rallies occur.

The evidence shows -- history shows -- that this is the best (sane) way for us individual investors to generate the kinds of returns we need to achieve financial independence.

If you're looking for some candidates, be sure to check out our free report "5 Stocks The Motley Fool Owns -- And You Should Too." These five companies were hand-selected by top Motley Fool equity analysts, and the Fool put real money behind their picks. Click here to get the report.