This article is by staff writer William Cowie.

In my previous post, a few commenters brought up the issue of market timing, generally taking me to task for appearing to advocate it. Market timing is a topic of much discussion, primarily in the world of stock investing. With this post, I hope to explain the issue and show how it applies to you, even if you never invest in a stock or mutual fund.

What is market timing?

The oldest investing advice in the book is “buy low and sell high.” Market timing is an attempt to do just that: Sell when the market is high; buy when it’s low. Obvious, right?

Obvious, though, is not the same as easy, because market timing, in essence, entails predicting whether the market will keep going the way it’s going, or make a turn, up or down, which is easier said than done.

Let’s say you wake up one morning, and this is the picture you see of a stock you’ve owned for about five years. (The chart is real, drawn from Yahoo Finance, but the name of the stock, and the dates, have purposely been blanked out, because most people’s first instinct will be to draw on historical knowledge to guess the outcome.)

Sell… or hold?

The stock has doubled in value in the five years you’ve held it. Hey, double is high, right? So should you sell today?

Answer: You don’t know. You don’t know if double is high enough or if you should hold the stock in hopes of more gains. Thousands of investors bought Microsoft at $1x, and felt good when they sold for $2x, only to see it go to $10x after they sold. On the other hand, many held AOL at $2x, hoping for $10x, only to see it drop to less than $1x.

The dilemma

Here’s the central dilemma underlying each and every investment decision you will ever make:

  1. Investing is all about the future.
  2. Nobody knows the future.

Every investing post, book or article you read, every hyperventilating-Jim-Cramer show you watch, every debate among investors revolves around that two-fold dilemma. All of us are trying to figure out how to obtain the best future outcome without knowing what that future holds. Some look to history to provide clues to the future, some look at rules or formulas which they presume determine future performance, and some use both. Those all may work some of the time, but there’s no such thing as a perfect predictor of the performance of any investment.

So there you are. You wake up in the morning, you don’t know what’s going to happen in the future, but you have to make a decision on whether or not to sell your lovely stock which has doubled in the past five years.

This might come as a revelation to you, but no matter whether you mean to or not, you are making that decision every day. Not making a decision is making the “hold” decision. Going to the Bahamas for a vacation and not looking at the stock is making a decision: Hold.

The exercise

So… back to the previous chart, what would you do? Before reading further, take the time to come to an answer.

Now, let’s expand the chart and see what happened. The dot on the line shows the point at which we cut it off in the chart above.

Hindsight 1: Should have held

The price of the stock kept rising. With the benefit of hindsight, the best decision would have been to continue holding. It almost doubled again in the three years following.

And then you wake up one morning to see it begin to dip, losing about 10 percent of its value (as you can see at the tail end of the chart).

Should you sell now since it is “high” or hold for even more gain? (As before, come to an answer before proceeding.)

Below is what actually happened. (Again, the dot represents the previous cut-off point.)

Hindsight 2: Should have held (again)

The stock, after that drop which might have spooked you, continued to climb almost 50 percent from the dip, and almost 30 percent from that peak just before the dot… in just 18 months.

Now you wake up on that morning at the end of the chart and see the stock climbing steeply. You have to ask yourself yet again: Sell or hold?

What would you do at this point? It’s been almost 10 years that this stock has risen, and it’s about five times the value at the beginning.

Can you see that timing the market is not easy? It’s like signing your name with your other hand — it sounds simple, but that doesn’t mean it’s easy to pull off. (In case you were telling yourself this is an individual stock, the market is easier to predict, well, this actually was the market. The chart is for the S&P 500 during the ’90s; this would be the chart you’d be following if you held an index fund. The price fell off a cliff right after the last chart ended.)

You can’t escape it. Timing the market is not easy.

It gets worse. You have to do this every single day. You never know if things are going to change that day, so you can’t take any days off. This particular chart covers almost 10 years. With about 250 trading days a year, you’d have had to do this 2,500 times, day after agonizing day, week after week, year after year. That doesn’t count the “worry days” — weekends and the other days the market is closed when you worry that you should have sold at the last opportunity you had. And that’s just for a single stock or index.

Conclusion

You get the picture. Even if you think you can make good predictions or you have a good formula, if you wanted to time the market with this stock (or index) you would have had to come up with 2,500 “hold” decisions in a row, and not a single “sell.” Think you could do that? Think anybody could do that?

Timing the market accurately, no matter what anybody says, is next to impossible. Forget the theory and all those academic studies. Timing the market is a daily exercise, and that is a strenuous affair. The odds are so against you, it’s even worse than gambling. There are a few reasons why it’s so hard:

  1. The future is impossible to predict.
  2. The human brain is not wired to make 2,500 “hold” decisions in a row without fatigue, fear, or some other form of indecision setting in, creating a “sell” decision. The “sell” decision, then, ends up not being a market-timing decision, but a human-brain-inadequacy decision.
  3. Nobody has identified exactly which variables turn the market, up or down. After the fact, it’s easy to reconstruct the cause of a turn, but those reconstructed reasons can’t be turned into a rule or program to predict the next turn.

Some people have attempted to create computer programs that won’t suffer from mental fatigue or fear, but the other two problems above make even that hard to pull off. Warren Buffett says he can’t time the market and so he, with as much humility as he can muster, recommends you don’t try it either.

This doesn’t stop many investors from timing the market, either directly or through the mutual funds they own (outright or through their 401(k) plans). The Investment Company Institute (ICI), a trade group for mutual fund managers, tracks the inflow and outflow of monies to mutual funds. They report that the biggest outflows from equity funds happen after a major market drop. The biggest inflows happen at times when the market is rising. In other words, millions buy high and sell low, and do it consistently every time the market surges.

Why? When the market goes up, the natural tendency for the human brain is to predict that it will continue rising. If the market drops, the same brain tendency is to predict continued dropping. The expectation for the future, then, is a continuation of the past. No turns, in other words.

Your options

There are various strategies people follow to deal with the dilemma of not knowing what the future holds. None of them are perfect, and consequently they all attract their share of critics. Warren Buffett’s strategy is called “buy and hold.” He buys with the view that he will never need to sell. He does time the market for his purchases, though. The classic example is his purchase of most of his Wells Fargo stock when the market whacked the price of that stock down to something like a P/E of around 5, if I recall correctly. So, I guess his strategy is “buy low, sell never.”

If you dig deeper into the market timing issue, it seems most questions focus on the “sell high” part of it. Most stocks, when the market plunges, recover their losses and grow further once the market recovers. Therefore, there’s little to gain if you try and sell high because it’s so difficult to pick the right spot to sell (as you can see in the example above). Buying low is a lot easier, because if the stock is reasonably priced, it can weather a temporary drop in price much better than one with a premium (high P/E) price.

However, you need cash to buy low, and where do you get that cash? Mr. Buffett always has a few billion clinking around in his pockets, but for you and me I that’s not quite so easy. Selling high is the tempting  answer, but it’s impractical, as we saw in the exercise above.

With that in mind, you can either be brave and try and time the market, or you can follow Mr. Buffett. You will hear critics spout things like “buy and hold are dead”; but the key question to ask is if their strategy can succeed for as long, and as consistently, as that of Mr. Warren Buffett. His track record speaks for itself.

This article is about Advanced, Investing