Don’t Fall Into the Market Timing Trap

One of the more interesting reactions to the Rebalance approach is hearing the ideas people have of “passive” investing and “market” returns, especially investors who still believe in market timing.

“Oh, I would never be a passive investor. There is too much money to lose that way,” some argue. They feel a primal urge to be active, to make choices with their money. Sitting still is impossible.

Often, investors confuse “market” with “average.” They are convinced that the broad stock market return is the floor for potential earnings, that any manager worth his salt easily exceeds the benchmarks.

Here is the thing about most investors: They get it exactly backwards. By being active, they chase the latest fad, goosing a single company’s stock higher and higher until it finally crashes back down.

At market bottoms those same investors panic, sure that a 40% decline in face value — an unrealized loss — is soon to turn into an 80% permanent loss, rather than the more likely course, a reversion to mean. So they guarantee the loss by selling near the bottom.

That is why active retail investors do so horribly when stacked against common market benchmarks. But what about the professionals?

Well, the news is not any better. After fees, extremely few active managers consistently beat their benchmarks. Often, they cherry-pick the recent past for examples of big wins, but their actions rarely match their words: They took too small a position to matter, or they got in late, got out early, or both.

Meanwhile, those active management fees pile up, irrespective of real performance.

Avoid falling into the market timing trap

What is the answer? Trading in the rear-view mirror.

The trick is to own a variety of investment types — stocks, bonds, real estate and commodities — and to rebalance among them with discipline. As for the investments themselves, you should own different parts of the market through inexpensive index funds.

That is how portfolio indexing works: You combine exchange-traded funds (ETFs) that track an index with modern portfolio theory, thereby creating a powerful, low-cost asset allocation plan.

Rather than trying to guess which investment will outperform next, passive investors own them all by way of broad-market index funds. When a given part of the market moves higher, for whatever reason, they sell off the gains and buy more of the ones in temporary decline, a simple and repeatable concept.

As investments diverge from their respective positions in the portfolio, it takes discipline to recognize the change and to rebalance. Emotions can cost you real money.

Market timing, thus, is the opposite of intelligent investing. It really is little more than a form of gambling, of “going with your gut.” Wall Street dresses it up by calling such trading “conviction” or “momentum” investing, among other phrases.

Every active investor has a strategy, a secret method he or she hopes will outfox the masses of ordinary, little-guy investors. Unfortunately, the research shows that active managers nearly always trail the pack, and they do so at great expense to long-term savers who hire them.

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