Why thinking you are smart enough to know where the market is going is so dangerous.

Why thinking you are smart enough to know where the market is going is so dangerous.

I wrote an article last week that talked about some of what I perceived as over-reaction and irrational thinking by some of the best minds in the personal finance world. Now granted some of the situations I pointed out weren’t exactly off your rocker moments, but I still think at some level they fell into the trap of reacting to the markets recent performance when when things started heading south (read the comments and this post to get Dave’s full story). Again I think these guys are financial wizards and a great place for sound financial advice, but just wanted to point out that we are all susceptible to thinking we can time the market or know where it is headed and can make more money by selling or deferring buying when the market is in a little slump. So I’m going to hopefully point out a few things here that show you why if you want the best possible returns you won’t be selling just because the market looks bleak at the current moment.

According to one of the Motley Fool stock letters that I subscribe to

“95% of the market’s gains between 1963 and 1994 occurred during 1.2% of the trading days.”

I think that is a pretty sobering statistic, that means in a typical year 95% of the gains would happen in just over 4 of the days of the year, which means if you got out because you were nervous and happened to miss one of these days you essentially would have no chance of getting anywhere near the market returns.

Another Fool article also paints a pretty black and white picture of what happens when people take their money out of the market because they “think” they know where it is headed

Between 1986 and 2005, the S&P 500 compounded at an annual rate of return of 11.9% — even while facing market booms and busts, war, 9/11, constitutional crises, and more. Over that 20-year period, $10,000 invested in the index would have grown to $94,555. Yet a recent report by Dalbar shows that the average investor’s return during that time was only 3.9% (so that $10,000 grew to just $21,422). The reason was simple: market timing.

When the market crashed in 2000, billions of dollars were pulled out of the market. Now, a full seven years later, some investors are just getting back in. Admittedly, it wasn’t an easy time to sit tight. When markets turn dark, investors are unwilling to commit to buying stocks even though it’s when some of the greatest profits can be made.

Ben Stein also recently chimed in on this topic in this article (I recommend reading the whole series especially Buffett & Miller)

No one is too stupid to make money in the stock market. But there are many who are too smart to make money.

To make money, at least in the postwar world, all you have to do is buy the broad indexes domestically–both in the emerging world and in the developed world–and, to throw in a little certainty about your old age, maybe buy some annuities.

To lose money, pretend you’re really, really clever, and that by reading financial journalism and watching CNBC, you can outguess the market day by day. Along with that, you must have absolutely no sense of proportion about money and the world at large.

He goes on to explain how insignificant the “subprime mess” is and how the “lazy stupid investor” who doesn’t follow the latest media hype in the market and only constently buys broad index funds and spends his time worrying about unimportant things like vacationing/fishing/etc. will beat the pants off the “smart investor” types who follow every intricate detail in the stock market and panic when the “sky is falling”. Pretty much a reoccurring theme here and why I cringe when I hear people talking about selling their stocks before the market goes any lower or putting of their regular investing until “things get better”.

I guess the biggest advice I could give you is to completely ignore every bit of financial advice that is out there trying to guess where the market is going and just blindly follow your investing plan (hopefully making regular bi-weekly/monthly/yearly investments into a broad based index funds). It’s that simple you don’t need to know anything about subprime lending, interest rate hikes, inflation, GDP growth, consumer spending, etc. Just set up your investing program and forget about it, in the end you will thank yourself as probably the biggest hindrance to most investor’s investing performance is themselves.