Written by Financial Advisor Hans Smith | July 13, 2020
Psychology and emotion play important roles in investing. Individual investors need to have the ability to manage their behavioral impulses, and control the buying and selling urges that so commonly erode portfolio returns.
A well-constructed diversified portfolio can help harness these emotions. Asset class diversification, along with a strong emphasis on risk management, can assist investors in maintaining discipline through a variety of market environments.
When equity markets are rising and investors are seeing results, maintaining investment discipline is relatively easy. Real willpower must kick in when a bear market arrives. That’s when the financial “noise” from media outlets tends to increase, and the temptation to try and time the market can grow considerably.
As advisors we are often asked, "Should I try to time the stock market?" I believe William Bernstein, the author of The Four Pillars of Investing, said it best: “There are two kinds of investors: (1) those who don’t know where the market is headed, and (2) those who don’t know that they don’t know where the market is headed.”1 Try to not be the latter!
There are two central problems with trying to forecast stock market movements:
1. During the month of April (2020), the United States reported record declines in manufacturing data, services, and consumer spending due to the impact of Covid-19. Unemployment figures rose significantly and the world economy came to a screeching halt. The overall US stock market responded by having its best month since 1987.2
2. Looking more specifically at historical unemployment data, here are a few statistics to consider:
Source: Charlie Bilello, Seeking Alpha, May 7, 2018. https://seekingalpha.com/article/4170913-unemployment-rate-and-stock-market
The statistics above tell a rather interesting story: Between 1948-2018 there was an inverse relationship between the level of unemployment and forward stock market returns.
This seemingly improbable relationship between historical unemployment rates and equity market returns has persisted because markets are forward looking3. In other words, expectations for future events drive price changes more than current information.
3. Extrapolating the data from Ned Davis Research below provides further illustration as to why timing the market is so difficult. The data between 1927 and 2018 suggests that a strong corporate earnings backdrop doesn’t necessarily bode well for stock market returns. When corporate earnings are robust, one might think that generous stock market returns would follow. As the table below illustrates, this is not always the case:
Source: Charles Schwab, Ned Davis Research (NDR)
Summary of the above table: Between April 1927 and April 2018, a year-over-year earnings decline of 10-25% was often the “sweet spot” for equity market returns. This is counterintuitive to what most investors would expect.
4. In my view, the financial media plays a role in convincing investors that timing the market is in fact possible. It’s critical to understand that they too don’t know where the market is headed, but yet their livelihoods depend on appearing to know.
The screen shot below was taken on December 20, 2018, three business days before a substantial bottom in the US equity markets. The takeaway is that listening to any market pundit can be a costly error.
CNBC Mad Money episode December 20, 2018
5. “Herd instinct” is a phenomenon in which investors follow what they perceive other investors are doing, rather than sticking to their investment plan. The AAII Sentiment Survey is a widely followed measure of the mood of investors as a whole, and a prime example of the dangers of herd instinct.
Here are the cliff notes from the AAII market sentiment survey results during the time period shown below:
Source: Is the AAII Sentiment Survey a Contrarian Indicator? - Charles Rotblut https://www.aaii.com/journal/article3/is-the-aaii-sentiment-survey-a-contrarian-indicator?viewall=true#table2
Next time you have a strong feeling about where the market is heading, try to imagine yourself as a participant in the AAII Sentiment Survey. Perhaps this will allow you to keep an open mind about the possibility markets could move in precisely the opposite direction of what you are anticipating.
When asking yourself, “Should I try to time the stock market?” consider the above data points. Instead of trying to time the market, here are a few strategies that we help clients implement during bear markets and periods of increased volatility:
1. Stay invested.
2. Collect dividends.
3. Rebalance the portfolio.
4. Tax harvest where appropriate.
5. Tune out the noise of the financial media and prediction makers.
6. Increase your 401k contributions and investing rates if your job is secure.
As an investor, if you’re able to tune out the noise and focus on the things you can control, investment success will likely follow.
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