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.

  • Right on the money, however the statement regarding the returns coming from just a small number of days is not a useful argument. The reason: that type of analysis only assumes you are missing out on the good days, while still hitting all the bad days. You couldn’t do that if you tried.

  • Jim

    Question: Is there a time when one should get out of the market? During the 99-2002 bear market, those who rode it down lost HUGE amounts of years long investment returns. In my case it took almost six years to recover to the same amount invested. Was I an idiot? Should one set a downside so the losses are limited to 20%, 30%, 50%? I can’t imagine riding this bear to the bottom is the thing to do.

  • MFJ

    @Jim – In my humble opinion you should NEVER get out of the market. To your point it sure is easy looking backwards and saying yeah I should have gotten out of the market in 99-2002, but the problem is you will never know which way the market is going to head and neither will any of the experts. The market goes up a lot more than it goes down so if you are out of the market you are essentially throwing away money.

    Let’s say you had the foresight or were lucky enough to pull your money out in 2000. When would you have gotten back in? Setting an arbitrary stop loss is pointless in my opinion as all you are doing then is selling low and buying back in later when the prices are on back up.

    The way to survive in bear markets is to keep investing regularly regardless of what the market is doing.

  • MJF, I have to both agree and disagree with you on this one. I think your advice is excellent, but I personally wouldn’t go as far as to say “you should never get out of the market” or that “you can’t time the market”. There are many investors who have done quite well and beaten the indexes by timing the markets in one way or another. While their success in be partially due to luck, I don’t think we can write them or their strategies off entirely.

    I think the point to be made is that most of us do not have the knowledge or time to dedicate to accurately research, analyze, and manage our portfolios in a way that can successfully outperform the market averages. There are a rare few that do, and some do quite well. Unfortunately many investors (or most at some point in time) tend to think they have an edge on the rest of the market and end up missing out on the long-term rewards of the market while chasing short-term profits.

    I personally don’t trust myself to try to “time the market” with my family’s long-term savings or retirement. I would consider myself an investing rookie and I don’t have the time, knowledge or industry insight to take that risk, so I keep a diversified portfolio invested in several funds. However, I do have some money (money that I can bear to take risks with) that I choose to use for short-term investments – sometimes buying stocks that I believe are undervalued, sometimes taking advantage of arbitrage situations, etc. I find it to be educational, fun, and (so far) profitable. Again, this is only a small percentage of my investing and only a handful of stocks and ETFs that I have the time to keep up with. So far I have over a 50% return on these investments (much credit to market conditions and some luck).

    I guess what I’m getting at is that there is a case to be made for recognizing investment opportunities and taking advantage of them. While we need to realize our limits and that there is a good chance we are not “above average” investors…I wouldn’t necessarily instruct people to stick their head in the sand and “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” either.

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