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John Law and the Mississippi Bubble
The Mississippi bubble is one of the biggest asset bubbles known to the modern world. This bubble first led France out of bankruptcy and straight into prosperity. Then this same bubble caused the opposite to happen, bankrupted France and gave an impetus to the revolution. This bubble was created when John Law, a renegade Scotsman […]
Should the Government be an Equity Partner in Infrastructure Projects?
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Stress Testing to Manage Risks in Financial Institutions
What is Stress Testing? Stress testing is a type of simulation model which is used to manage risks in banks and other financial institutions. As a part of stress testing, various mathematical and analytical techniques are deployed to understand how an organization would react to adverse outcomes in the external environment. Stress testing is useful […]
Changing Cost Structure in the Retail Industry
The retail industry has undergone a lot of changes in the recent past. Each of these changes have been strategic in nature. As a result, their impact has been more or less permanent. This impact can be seen and felt in many ways across the entire retail organization. One of the ways in which this […]
Stock market investments can be akin to gambling depending on the procedure used for making these investments. If the investments are rooted in fundamental research, then they are the result of skilled judgment and therefore cannot be called gambling.
On the other hand, many investors invest in the stock market as if it was a game of chance. They pick random stocks either because of their own whims and fancies or because of the recommendations received from some equally whimsical third party. This turns stock market into a game of chance since very little attention is paid to the underlying fundamentals. Most experts on finance would agree that this is a bad idea!
In this article, we will expose the pitfalls of the philosophy that encourages people to time the market.
Retail investors do not have an understanding of the functioning of the stock markets. Also since they pursue other full time jobs, they do not have the time or the resources required to undertake such an education. In theory, the market is made up of people who understand the consequences of their decisions. However, in reality that is not the case at all.
The average retail investor would rather believe the recommendations of so called “experts” and invest their money rather than delve into the details themselves. The problem is compounded when because of sheer probability some of these recommendations turn out to be right. A false belief is created that money can be made on the basis of such baseless and misleading stock market tips.
Market timing is a flawed strategy and we need not look beyond probability to prove that. Consider the fact that market timing entails two decisions. One decision is regarding when to get into the market whereas the other decision is regarding getting out of the market.
If we were to ignore the important details and simply calculate probability. There is a 50% chance of getting one decision right. Therefore, there is a 25% chance of getting both the decisions right. Hence it is likely that one in four bets will make money whereas three will lose money!
People who believe in market timing have no clue that the odds are heavily stacked against us. In reality there is less than 10% chance that they will make a profit. Also, if they actually do make a profit, it ends up being lost in a future bet.
Studies have repeatedly shown that retail investors who believe in market timing tend to lose money almost certainly!
The myth of market timing is perpetuated when some retail investors make some money in bull markets. They do not realize that a rising tide lifts all ships and their bets are going right because the market is simply bullish.
Timing the market with any sort of consistency is almost impossible. Even the best investors in the world like Warren Buffet have an ROI percentage in the range of 25% to 35% per annum. It is weird to see the average person believe that a profit of 5% per day is even a possibility!
Investors who believe in timing the market are very profitable for brokerage firms. The more stocks are bought and sold, the more commission is due to these firms. However, the commission is paid from the investor’s pocket regardless of whether there is a profit or a loss being made! Also, the government takes a higher rate of capital gains tax on proceeds earned by timing the markets.
Long term investors do not have to face nearly as many costs as these short term market timers. These costs eat into whatever little profit they might earn seriously diminishing the returns that have been generated.
The strategy of market timing becomes even worse when emotional reactions get mixed with it. Retail investors are highly reactive to both greed as well as panic. Also, they are very sensitive to both profit and loss. This behavior is what creates short term bubbles in the market. Retail investors are the ones that the react the fastest to both greed as well as fear. As a result they buy when prices start rising and sell when prices start falling i.e. the exact opposite of what should be done to make a profit!
The record of history is crystal clear. There is no investor that has made millions and billions by timing the market. This is an idea that is propagated by conmen to deceive working class people out of their money. The idea that someone will give you a sure money making tip is also bizarre. If they had such information, why would they pass it on to you for a small fee, when they could have been the ones making the outrageous money themselves!
Mutual funds and other professional money managers are able to get away with market timing because of their size. These funds invest huge sums of money and as a result move the market. Hence, when they time the market, they spark the greed and fear that propels retail investors into action. The funds and the retail investors therefore use the same strategy. However, it works for the funds since they are able to find a greater fool i.e. the retail investor whereas it doesn’t work for the retail investor because there is no greater fool left!
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