Monday, August 31, 2009

The danger of Market Timing. Market Timing doesn't work. Stock Trading and Mutual Fund Lessons.

Market Timing: The Most Dangerous Game

With all of the research that shows humans—even experts—have pretty terrible predictive abilities when it comes to economic and stock market issues, you'd think that people would refrain from trying to predict the market's short‐term movements. They don't. Every day, millions of investors try to discern where the market will head tomorrow, next week, or next month. And the way this manifests itself is the doomed practice of market timing.

Market timing occurs when people move in and out of the stock market with the intent of taking advantage of anticipated short‐term price movements. Market timing can be as simple as you want it—maybe you've heard from a friend that the market is about to take off, so you invest in stocks—or as complex as you want it—perhaps you've developed an elaborate model that uses various economic indicators to predict which way the market will go in the next month. Whatever way you go about it, though, it's not likely to end well, because the market is simply too complex and irrational in the short‐term for anyone to correctly and reliably predict its movements.

Want proof that market timing doesn't work? There's plenty. Take, for example, the research performed by Dalbar, Inc. In its “2 Quantitative Analysis of Investor Behavior,” the firm notes that the S&P has grown an average of 11.8 percent per year from 1987 through 2006, an impressive gain. During this period, however, the average equity investor averaged a return of just 4.3 percent. The reason? As markets rise, the data shows that investors “pour cash” into mutual funds, and when a decline starts, a “selling frenzy” begins. In other words, the research shows that investors tend to do the opposite of the old stock market adage, “Buy low, sell high.”

Dalbar isn't the only firm that's found that investors do a pretty awful job at trying to time the market's short‐term moves. A few years ago, the investment research company Morningstar began tracking mutual fund performance in a new way. Normally, mutual fund returns are reported as though an investor remained invested in the fund throughout the full reporting period. A fund's three‐year return, for example, is reported as the percentage increase or decrease an investor would have seen if he had been invested in the fund for the entire three previous years.

In a methodology paper (“Morningstar Investor Return”), Morningstar says it found that this “total return” percentage doesn't accurately portray how well investors in a particular fund really fare. The reason: While the “total return” percentage measures how a fund does over a specific period, people often don't stick with the fund for that entire period; instead, they jump in and out of it. And, according to Morningstar, the returns that the typical investor in a particular fund actually realizes (the “investor returns”) tend to be lower than the fund's total return—implying that people pick the wrong times to jump in and out of the fund (or the market).

While investors themselves deserve some of the blame for this, mutual funds sometimes don't help. In its investor returns methodology paper, Morningstar states that if firms encourage short‐term trading and trendy funds, or if they advertise short‐term returns and promote high‐risk funds, they may not be looking out for their investors' long‐term interests. Their investors' actual returns will likely be lower than the fund's total return. (The fees mutual funds charge also don't help, something Bogle stresses; those costs make it so that the fund manager has to beat the market just for his client to net market‐matching returns.)



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