Updated: Jun 4, 2020
When the economy goes into recession, or there is a big drop in the stock market, you will see countless articles that cite “experts” that advise investors to sell their stocks now before things get worse.
The idea is to sell your investments today to avoid an upcoming downturn and future losses. The technical term for this idea is “market timing.”
Intuitively, timing the market during a recession sounds smart. After all, who wouldn’t want to avoid steep losses that experts say are right around the corner?
In this article, I’m going to review why market timing is always a bad idea, even in a recession and why you shouldn’t rely on the opinions of “experts” when making investment decisions.
Don’t listen to the experts
“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” -Laurence Peter
As an economist, I can confidently say two things are true about economists:
They are intelligent people that we should listen to more when developing public policy.
They are terrible at accurately forecasting the future.
The most brilliant people I’ve ever had the privilege of knowing were my economics professors. When it comes to setting public policy that maximizes the public good, we would be well served to listen to economists more often.
When it comes to making accurate predictions about what the economy or the stock market will look like a year from now, economists do their best but often get it wrong.
One reason economists are notoriously bad forecasters is that economists look at the world with a hyper-rational lense. Their models assume that people, companies, and governments will always make a rational decision.
In reality, we know this is not true.
People are irrational by nature. Since people run companies and governments, they will often make irrational decisions.
However, there is bigger problem economists face beyond the assumptions they use in their models. Economic forecasts are often wrong for the simple reason that it’s impossible to predict the future.
The stock market is not the economy
Let’s pretend that economic forecasts were 100% accurate. For market timing strategies to work, you would have to assume a high correlation between the current state of the economy and stock prices.
But there is an important point that very few people understand; the stock market is not the economy.
This tweet by Alexandria Ocasio-Cortez is a perfect entry point to explain how people conflate the current state of the economy with what’s happening in the stock market and why the two are not related.
The Tweet shared a screenshot of Jim Cramer’s TV show with a graphic that reads “The Dow’s best week since 1938”, while a breaking news scroll at the bottom of the screen reads, “More than 16 million Americans have lost their jobs in 3-weeks”.
AOC Retweeted the screenshot with a caption that read, “when late stage capitalism takes a selfie.” With the implication being that capitalism is somehow broken because of the stock market had one of it’s best weeks ever while the economy had one of it’s worst.
In terms of persuading people to your point of view, this was a great tweet. It’s intuitive, the visual speaks for itself, and the caption was short, snappy, and funny.
The only problem with the Tweet is that it’s wrong. The reason the stock market and the economy can be so disconnected is not a fatal flaw of capitalism.
It is because economic data has minimal impact on stock prices.
To understand why you need to know some basics about how stocks are valued and economic data is reported.
Economic data is backward-looking. When we receive a report about how many people have lost their jobs, that is something that has already happened several weeks or months ago.
Stock prices are forward-looking. A company’s stock price is driven by the expected future earnings of that company and the market’s confidence in that companies ability to deliver those expected future earnings.
When there is a significant shock to the economy, investors and everybody else is aware of that fact long before the official economic numbers are reported.
If millions of people are losing their jobs in March, that information gets priced into stock prices immediately. Investors don’t wait until April to react to what’s happening to the economy in March.
The only impact that backward-looking economic data has on stock prices is if the data was better or worse than what investors expected.
If investors expected 20 million people would lose their jobs, and it turns out only 16 million lost their jobs; that would have a positive impact on stock prices.
If investors believed 10 million people would lose their jobs, and it turned out, 16 million people lost their jobs, that would hurt stock prices.
By the time you read a forecast from an economist that says the economy is going to go into recession, that information has already been factored into the stock market.
Even if economists were right 100% of the time, it would be nearly impossible to time the market and make a profit off that information because of the speed of which new information gets priced into the market.
Timing the market is smart on paper but too difficult to pull off
Market timing strategies are justified by speculators who believe that the stock market does not price in new information efficiently.
So, for the sake of argument, let’s pretend that economists were right 100% of the time and that these forecasts are not efficiently priced into the stock market.
In that scenario, it would be possible to time the market and avoid steep losses from a coming downturn in the economy.
To successfully time the market would require you to know two things:
Exactly when to pull your money out of the market.
Exactly when to put your money back into the market.
The odds are that you would sell too early and buy back in too late. In the process, you would lose all the benefits of market timing and expose yourself to the risk of missing the market’s biggest gains.
Even in a perfect world, market timing is simply too hard to pull off.
The risk of market timing
When an investor pulls their money out of the market, they are making a gamble that the stock market is going to go down in the short term.
The stock market can be wildly unpredictable, especially in the short run. If everyone is predicting economic disaster and those predictions are priced into the stock market, what happens if the economy does better than expected?
Stock prices will go up, and probably by a lot. If your money was sitting on the sidelines, you missed out on those gains.
Merril Lynch has researched this subject in more detail. They examined the return on a $1,000 investment in the S&P 500 from 1989–2018 under three scenarios.
Scenario 1: The investor implements a buy and holds strategy.
Scenario 2: The investor pulls their money out of the market and misses the ten best performing months.
Scenario 3: The investor pulls their money out of the market and misses the 20 best performing months.
The results demonstrate the risk of market timing.
The buy and hold investor ended with $17,306, a 1,631% return on investment.
The investor who missed the ten best performing months ended with $6,959, a 596% return on investment.
The investor who missed the 20 best performing months ended with $3,328, a 233 % return on investment.
The risk of market timing is that you’ll miss out on the stock market’s best months, which often happens when economic data turns out to be better than expected.
Stick to your plan
I completely understand the urge to want to time the market. When everyone is predicting that the economy is about to fall off a cliff, the knee-jerk reaction would be to pull your money out of the stock market.
The problem is that by the time you are aware of these economic forecasts, they have already been priced into the market. This means stock prices have already fallen, and you missed your chance to time the market.
The risk of market timing is that the economy performs better than predicted. When that happens, stock prices rise rapidly. If you’ve already pulled your money out, you’ll miss those gains.
The fact is, market timing is simply too difficult to pull off. If you have a long term investing plan, the best move is to stick to your plan.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions