Friday, January 8, 2010

Once Burned, Twice Shy

As we start the new year a hot topic of conversation in the financial world revolves around 'what the market is going to do.' Despite it's popularity, this is a futile question to spend time thinking about because:

1) no one - and I mean no one - really knows the answer (despite how good the talking heads might sound, the crystal ball has yet to be invented that can predict the market);

2) investment returns are just one - and far from the most important - of many factors affecting financial success (things like how much you save, how much you pay in taxes, and how stable your relationships are have a much greater impact on net worth than investment return); and

3) even just on a portfolio-specific level, the short-term direction of the market has little bearing on the long-term performance of a properly diversified portfolio.

My Alliance of Cambridge Advisors colleague Bert Whitehead wrote a great piece on the perils of forecasting and market timing on his blog. Here is an excerpt:

It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.

Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?

This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.

If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.

Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.

You can read his whole posting at

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