IT’S THE GREAT investor fantasy: Quit the stock market at the top and buy back in at the bottom. While the lure of market timing sells millions of books and is standard fodder for financial television, the reality rarely lives up to the promise.
History is littered with the failed dreams of market timers. Less than five years after the nadir of the financial crisis, some pundits were saying U.S. stocks were overvalued. Another five years on and the market had gained more than 60%.
Not even the gurus have much of a record. Back in 1996, Federal Reserve Chairman Alan Greenspan warned of “irrational exuberance” in the stock market, and yet the market climbed for another three years before the dot-com bubble finally burst.
Even if your logic about valuations is impeccable, there’s no guarantee the market will come around to your view. As someone once said—no, it wasn’t John Maynard Keynes—markets can stay irrational longer than you can stay solvent.
But the most overlooked challenge with market timing is that it requires you to make two correct decisions: You must get out at the right time—and you need to know when to get back in.
Think back to the global financial crisis. Plenty of people were throwing in the towel by early 2009. But how many bought back into the market in time to enjoy the big bounce that followed in the second and third quarter of that year?
The fact is, market timing is tricky, because big gains and losses can come in relatively short periods. Not even the professionals have much of a track record in successfully negotiating these unpredictable twists and turns.
If market timing is a mirage, what can you do? Here are five alternatives that make more sense—and none requires a crystal ball:
1. Take the long view. “The historical data supports one conclusion with unusual force,” the index fund pioneer Jack Bogle once wrote. “To invest with success, you must be a long-term investor.”
Instead of trying to time the ups and down of the markets, why not simply change your time horizon? Over the very long term, patient stock investors holding diversified portfolios have almost always been rewarded. To be sure, not everyone can take the long view, such as those who need to access their money within the next two or three years—which is why these folks shouldn’t have this money invested in stocks.
2. Build a portfolio for all seasons. Everyone should have a balanced asset allocation—certainly a mix of stocks and high-quality bonds—that matches their capacity for risk. Defensively minded investors might have just 50% or less of their portfolio in stocks, with the rest in bonds.
The right mix also depends on your age, goals and circumstances. Whatever your risk capacity, diversification is key. Spreading your risk across different asset classes and geographies will reduce the impact of a steep decline in one particular market. Ultimately, it’s your asset allocation that’s going to be the most important driver of your investment returns.
3. Rebalance occasionally. In general, the less you tinker with your portfolio, the better. That’s not to stay you shouldn’t touch it at all, but any changes you make should be done in a strategic, structured and disciplined way that reflects your needs and circumstances.
A good discipline is to rebalance your investment mix periodically, so you bring its asset allocation back into line with your target portfolio weights. This means, every year or so, lightening up on some of the winners and adding more money to the losers. This effectively forces you to sell high and buy low, which is what you should be doing.
4. Drip money into the market. If you’re worried about the stock market and want to reduce your risk, try dollar-cost averaging. Say you have a sizable sum—perhaps an inheritance or a year-end bonus— that you want to invest. Instead of going all in and investing the full amount in one go, you can drip small amounts into the market over a period of time. Economists don’t think this approach makes much difference from an investment perspective. You might end up with slightly lower returns. But it’s a useful way of helping you sleep at night and minimizing regret.
5. Carry more cash. Everyone should hold enough cash to cover three to six months of living expenses, in case of, say, unexpected medical bills or you lose your job. But nervous investors may want to keep more cash than that. The advantage: Your portfolio will hold up better in a market downturn, plus—if you’re feeling courageous—you’ll have extra cash to put to work when share prices are lower.
Robin Powell is an award-winning journalist. He’s a campaigner for positive change in global investing, advocating better investor education and greater transparency. Robin is the editor of The Evidence-Based Investor, which is where a version of this article first appeared. His previous articles were Writing Wrongs, Private Matters and Where’s the Value? Follow Robin on Twitter @RobinJPowell.