Reblog: The dangers of timing the markets

We’ve witnessed shock after shock in the political arena over the past year, which has repeatedly jolted the markets into action.

For investors, it’s difficult to sit tight amid all this noise, and you might feel encouraged to sell out of stocks to try to protect yourself from the falls. But by selling out early, you could end up missing out on the gains.

Timing the markets is effectively a double whammy in crystal ball gazing, because not only do you have to predict the outcome of these events (and just note how shocked most of us were about the Brexit vote), but also how the markets are going to react.

Disaster domino effect

Mark Northway of Sparrows Capital says the events which have transpired over the past year have provided opportunities for fund managers to “test their mettle” and trade in and out of the turbulence.

Of course, it’s possible for investors to scoop up juicy returns by timing the market, but recent events have shown that this strategy doesn’t tend to work.

For example, in the nine months after the Brexit vote, UK investors pulled £6.4bn from European equities, despite returns from the Eurozone gaining momentum last year and outperforming the US market.

Northway points out that one investment decision often leads to another and, if any of the decisions in the chain are wrong, there’s a domino effect that causes an increasingly worse performance.

This means that if you make a decision to sell a stock based on your forecast of future events, you have to make a decision to buy again at a later point, and either or both predictions could end up being incorrect.

Missing out on the upturn

If you sell during a downturn in order to remove some of the risk, you could leave the portfolio under-invested during the ensuing recovery.

This means you might miss out on the benefits of the upturn if this timing is wrong. And if you buy a stock when it’s performing well, it’s more likely to be overvalued.

Also be aware that you can incur trading costs by chopping and changing your holdings, which eat into your pot of money.

Sparrows Capital recently reviewed the performance of several third-party managed portfolios, comparing their performance and taking into account their asset allocation decisions over eight to 10 years. The data revealed that the biggest factor contributing to shortfalls was the fund manager’s tactical asset allocation. In other words, timing the markets backfired.

This shows that even professional investors get it wrong.

Psychological pitfalls

So the question is why do investors pay for the privilege? The answer is deeply rooted in psychology.

“Investing is a complex, skilled business, and we are programmed to believe that our money should be managed by a specialist who knows how to avoid pitfalls and how to identify opportunities,” says Northway.

“This is mirrored by many managers who genuinely believe in their ability to predict future market directions, despite the historical evidence to the contrary.”

Luck and noise

The Sparrows Capital investment manager says anyone who manages to make a return through timing the markets is simply gaining from a “confusing combination of luck and noise”.

A major pitfall when investing is an overconfidence in your ability to correctly predict market movements. Ian Heslop, who heads up the global equities team at Old Mutual Global Investors, says: “humans are good at correctly timing some things, but bad at timing others.

“When it comes to large scale, complex systems – such as financial markets – we may be worse at trying to time events than we would like to believe.”

For example, each time the Federal Reserve raised interest rates over the past two years, the S&P 500 reacted differently in the months after – by moving up, down or sideways.

So if you’d based your prediction on previous market movements, you would have been wrong every time, despite this being the same macroeconomic event.

Interpreting chaos

Heslop explains that markets have elements of both chaos and regularity, and he thinks it’s important for investors to try to be as objective as possible by focusing on the here and now.

This means you should observe the impact these big issues have on the state of the market itself, rather than trying to predict the market’s direction of travel.

For Heslop, it’s about understanding which stock selection techniques will be most effective in the current market environment, rather than attempting to time it. “With that in mind, our conviction is less on an individual stock level, and more around what investment style is suited to the current market environment in which we find ourselves.”

Clouded judgement

Try not to let yourself fall victim to the barrage of input which might cloud your judgement by encouraging you to take action, when sometimes it might be wiser to do nothing.

Make sure you remind yourself how your investments fit into a long term plan so you don’t take rash decisions based on a paltry amount of evidence. And ultimately be conscious of your own fallibility.

The original article is penned by Katherine Denham, appears on cityam.com and is available here.