Financial Literacy: Market timing
The biggest mistake novice investors make
“The market will fluctuate.” That old bit of market wisdom is ascribed to Gilded Age financier J.P. Morgan and is as true today as it was a hundred years ago. The primal emotions of fear and greed are ultimately at the bottom of all market movement, and they take turns confounding market watchers, analysts, and investors. Trouble is, no one ever knows when there will be a market top (or bottom). And that often gets novice investors into trouble when they start trading stocks.
Currently the markets are still scaling new heights, with the major equity indices marking record highs almost daily. Take a look at the chart of the S&P 500 Composite Index, the main U.S. blue-chip stock index, below.
One of the longest bull market phases in history just keeps piling up new gains. Except for a shallow retreat in late 2018, the stock market just hasn’t seen a major pullback since 2008. That has some market watchers taking defensive positions, worried that valuations are far too rich and that a correction or a bear market can’t be too far away. But other investors are wondering whether they should sell their bond holdings, gather all their cash, and plunge everything into stocks to try to cash in on the last market blast before a blowoff occurs.
However, neither of those approaches would be the prudent choice. That’s because both are really emotional responses to the prevailing market condition – one response is fear (“Valuations are too rich, and I should get out now!”) and the other is greed (“Valuations are too rich, and I should get in while I can!”). And both are bound to fall short of the investor’s ideal outcome for a very simple reason: No one can ever know precisely when a market top (or bottom) will occur, and attempting to do so – a process called “market timing” – often ends in either steep losses or missed opportunity.
Instead of reacting to unusual market conditions with an all-or-nothing attempt at market timing, the most successful investors apply three proven investment management principles.
When you and your advisor develop an investment strategy and build a portfolio to execute that strategy, you’re doing it to achieve a stated financial objective within your risk comfort zone.
For example, you might have settled on a broad asset mix of 10% cash and risk-free holdings, 50% fixed-income, and 40% dividend-paying equities. That allocation will serve you well, but only if you stick with it. Your equity holdings will fluctuate more than the other allocations, of course, but that should be offset by income from dividend-paying securities and from the less volatile fixed-income allocations. In other words, you have diversified your portfolio to mitigate the risk associated with a concentration in just one type of security.
Whichever strategy you’ve decided on, the key is to maintain investment discipline. Market conditions change continually. If your portfolio asset allocation met your needs before, and the security selections made sense, what’s changed? Are those big blue-chip companies suddenly on the verge of bankruptcy? Will the government default on its bonds? Of course not! But the markets will fluctuate. The discipline lies in making sure you don’t blow up your portfolio at every turn – because you’ll almost certainly do it at the wrong time.
The longer you apply your disciplined approach to portfolio management, the more likely you are to meet your objectives for wealth creation. For example, a $10,000 investment, with $100 added monthly, growing at an average 7.3% return compounded annually, would be worth $61,500 after 15 years. Only $33,000 of that would be deposits you’d have made. The rest is pure growth.
Why did I choose the 7.3% rate? That’s the annualized rate of return for the S&P/TSX Composite Index over 15 years to Nov. 6, 2019. Over that period, of course, the stock market has gone through a number of ups and downs, which would have tempted many fear-and-greed-driven investors to jump into or out of the market at precisely the wrong time. The important principle here is that you’d have made this small fortune only if you’d stayed in the market. And you’d have done that only by exercising patience.
The third principle, prudence, acknowledges that you are unlikely ever to achieve your goals by acting on “hot tips” or “great ideas.”
When you establish your financial objectives, define your true risk-tolerance level, and decide on an appropriate asset mix, your framework for wealth creation still needs a systematic method of selecting individual assets with which to populate your plan. It’s here that you want to have the best professional asset management talent available with access to top-notch research and financial analysis tools.
You can always do it yourself if that sort of intensive number-crunching is in your wheelhouse. For most people it isn’t, so it makes sense to hire the expertise. Ask your financial advisor who they use for asset management and what their financial-management philosophy is. Get the facts and figures and proof of performance.
With the application of investment discipline, patience, and prudence, you’re much more likely to achieve your financial goals. And you won’t have to worry about what the market did yesterday.
Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at email@example.com for a confidential planning consultation.
Notes and Disclaimer
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The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.