Every time the market drops sharply, the same questions come up. Should I sell before it gets worse? Should I wait on the sidelines until things calm down? Should I move everything into bonds or cash? The idea of timing the market, getting out before a decline and back in before the recovery, is always appealing when markets are volatile.
Why market timing rarely works
In theory it makes sense. In practice, it is extremely difficult to pull off. You usually can’t identify a market top or bottom until well after it has passed. If you sell during a decline, you then have to decide when to get back in, and by the time it feels safe, the market has often already recovered much of what it lost. Some of the market’s best days have historically come right after some of its worst, and missing just a handful of them can do lasting damage to long-term returns.
Even the professionals struggle. A study by CXO Advisory Group tracked more than 4,500 forecasts made by 28 self-described market timers between 2000 and 2012. Only 10 of them were right more than half the time, and none were accurate enough to beat the market. Nobel laureate William Sharpe calculated that a market timer would need to be right about 74% of the time, on both the way down and the way back up, just to match an investor who stayed put in a portfolio of similar risk.*
What to do instead
- Don’t panic. Selling into a falling market is often the surest way to lock in a loss. Research in behavioral finance shows that emotions lead investors to overreact to recent events, even when those events don’t change the long-term picture. If your strategy made sense before the downturn, it very likely still makes sense afterward.
- Focus on time in the market, not timing the market. A well-built strategy based on your goals, time horizon, and tolerance for risk is a better ally than predictions. While past performance is no guarantee of future results, the stock market has historically recovered from every downturn.
- Keep enough cash for near-term needs. Retirees who hold a year or two of spending in cash or short-term investments are much less likely to be forced to sell stocks at a bad time. My midyear retirement income checkup covers how to size that reserve.
- Rebalance rather than react. Periodically bringing your portfolio back to its target mix means you trim what has done well and add to what has lagged, a disciplined way to buy low and sell high without guessing.
- Talk to your advisor before you act. A second opinion can help you separate an emotional decision from one based on your plan.
Volatility is a normal part of investing. The goal is not to avoid every decline but to have a plan you can stick with through them. For more on this, see Common Retirement Investment Mistakes.
*Source: Index Fund Advisors, Inc. (IFA.com), based on a study by CXO Advisory Group LLC.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
