The efficient-market hypothesis argues that all valuable information is reflected in stock-price movements in a timely, accurate and adequate manner, including the current and future value of the corporation. Unless information is hidden, or there is some form of market manipulation, it’s therefore very hard for the average investor to earn higher than-market returns through active management.
Buying a stock on good news or selling it on bad news, for example, is not an effective strategy because, by the time the average investor has received the news, it has already been incorporated into the market price. Corporations report their earnings on a quarterly basis, but a lot of information about the company’s prospects will also emerge throughout the course of ordinary business dealings. This information, whether positive or negative, tends to emerge randomly, resulting in random fluctuations in a stock’s price.
While an analyst or portfolio manager may be able, on occasion, to anticipate the release of this information, the average investor is hard pressed to do so — meaning that the best way to make money is by staying in the market for years, rather than trying to anticipate market movements based on predictive methods, aka market timing. In the real world, regardless of the hypothesis, market inefficiency does exist.
Insider trading does occur. Investors do sell below market value, either because they are forced to or because they’re acting irrationally. Being able to capitalize on these inefficiencies, however, requires a great deal of market knowledge and discipline; for the average investor, market timing is exceedingly difficult.
For instance, it may seem logical to stay on the sidelines when markets are down. By doing so, you may think that you could avoid the worst of the market crash and wait for opportunities to deploy capital at better prices.
However, since the market is extremely difficult to predict and the market’s best days typically follow the largest drops, panic selling can lead to missed opportunities on the upside. As Figure 1 demonstrates, the risk of losing money as markets fall is more than eclipsed by the risk of missing out as markets rise. If you invested $10,000, and missed the best 10 trading days between 1928 and 2021, for example, their overall returns would drop from $2.7 million to $894,000.
The lesson is simple: you should avoid the impulse to time the market. Timing the market also comes with another big opportunity cost — namely, the time required to monitor the market on a daily or even hourly basis. Even if you’re willing to put in the time, however, you cannot hope to compete with the reams of fundamental, quantitative and economic analysis that portfolio managers have at their fingertips.
Gauging the future direction of the market is hard. Investors who attempt this are likely to underperform significantly. Of course, anyone can get lucky by selling before a downturn or buying before a rally. Anyone can make one or two bad decisions with a good result, but you can’t make a series of bad decisions over the long term and not have it end badly. Instead, it pays to adhere to a proven investment philosophy, and focus on investment goals instead of reacting to events and short term market swings.
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Frequently Asked Questions
Q: What is the efficient-market hypothesis?
A: The hypothesis states that asset prices reflect all available information and, because new information emerges randomly, it’s extremely hard to predict market movements.
Q: What is market timing?
A: Market timing is the attempt to determine the best time to enter and exit the market based on predictive methods.
Q: What are some risks and disadvantages of market timing?
A: Timing the market is exceedingly difficult, given that it requires continuous monitoring, which can be time-consuming and draining. Market timing also requires professional expertise in fundamental, quantitative and economic analysis. The primary risk of trying to time the market is that an investor will miss out on critical rebounds, which more than make up for market crashes. Market timing can easily lead to “performance chasing,” which is ultimately harmful to investment performance.
Q: How can you avoid market timing?
A: Instead of getting distracted by short-term market swings and performance-chasing, investors should stick to long-term investment goals that are consistent with their risk tolerance and liquidity needs.