Trying to time the stock market is a bad idea – here’s why
Day traders, beware. There’s an ever-growing mountain of evidence that even the most sophisticated professionals can’t consistently outperform the market – most of them don’t even beat the benchmarks of index funds in any given year. If you are thinking of figuring out which days stocks will go up and down, it might be time to consider a new strategy.
Fortunately, there are investment strategies that don’t require you to predict the stock market perfectly, but they will still offer fantastic returns regardless of the time.
You have to time it more than once
This is one of the simpler challenges of active management, but it is almost always overlooked. In the most basic sense, you make money by buying stocks at a low price and selling them at a high price. This means that you need to determine not only when to buy a stock, but also when to sell it. If you think a stock is cheap and now is a great time to buy, that’s good. But you have to recognize that you only take profit by selling in the future.
The same applies if you think a stock is expensive and it’s time to exit – you create a future obligation to repurchase, and you will need to determine when to actually execute that trade.
If the probability of perfectly timing a market low is low, then the probability of doing so followed by a perfect timing of a market high is much lower. Worse yet, daily stock index performance data indicates that there is very little room for error. You might think that timing things correctly over a matter of weeks or months can be effective, but you actually need a lot more precision.
A small number of days generates a large proportion of returns
There are many studies showing the same pattern over different periods of time – the S&P 500the growth of can be attributed entirely to a small number of days.
One article found that over a 20-year period, the best 35 days represented all the gains during that period. That’s less than 1% of the more than 5,000 trading days over two decades. Even more frustrating, many of the best days in the market occur in the week of the worst days. This is the problem.
Systematically timing the market would therefore require incredible precision. Any active traders looking to time the market may have completely sabotaged their performance if they missed any of those few days. If you stay invested, you implicitly “buy” on down days. If you get too active, you run the risk of buying high and selling low.
Investors need to understand the mechanisms of market fluctuation. Most price movements are small and generally unrelated to information about companies’ financial performance. The average month has four days when the index gains or loses more than 1%. Otherwise, there are a few more days of rising than days of falling.
Individual stocks behave the same, although each stock tends to have days when it fluctuates a bit more than the major indices. The key to consistent long-term growth is being invested when these big days of market-wide growth strike. It also helps to own at least a handful of stocks that offer fundamental growth in a way that can overtake the market. If you hold a few different stocks for the long term, you will increase the likelihood of dividing the returns when these great sessions take place.
Entry points are less important in the long run
It’s hard to dispute the overwhelming evidence above, but the promise of big profits is always alluring. This can cause investors to act irrationally and ignore their best judgment. If you are still tempted, it may help to recognize that entry points become less and less meaningful over the long term. In any given year, the exact day you buy a stock can mean the difference between big gains and big losses. This is not the case at all if you are considering a 20 year window.
Bank of America recently published an article that quantified the effects of missing the 10 best and worst trading days for each decade, based on daily returns of the S&P 500. The authors found that someone who had invested in the S&P 500 from 1930 to 2020 would have achieved a return of almost 18,000%. If someone misses the top 10 days of each decade, that number drops to 28%.
The authors noted that it can take more than 1,000 trading days to overcome bear markets and that valuation is by far the most accurate predictor of returns over a 10-year period.
Again, this shows that good long-term allocation is a superior strategy to stock picking for short-term returns. It’s okay to make modest adjustments to your stock portfolio as conditions change for the individual business, the stock market as a whole, and the economy. However, investing for short-term gains is something that even the majority of professionals cannot do successfully and consistently.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.