Module 1: Chapter 6
In the chapter active investing vs passive investing, we touched upon the concept of alpha, or investors’ desire to generate returns that are more the benchmarks like Nifty or Sensex.
While creating a customised portfolio, which is different from the constituents in the Nifty is one way to generate alpha, a more common technique attempted by investors is timing the market.
Put simply, timing the market means deciding to buy or sell anticipating a change in trend just before it happens. Most experts believe that timing the market is a futile exercise, and that investors are better off remaining invested in markets all the time, instead of trying to be overactive.
But what does the data say about timing the market? Is it possible to time the market? If yes, who should time the market? Timing the market can sometimes be dangerous for investors
Dilemma of Investors
Theoretically, the market is supposed to be an efficient machine, where prices factor in all available information. However, in reality, this is not the case.
Most investors, be they be newcomers or veterans, are subject to emotional biases. This results in prices far from being perfect.
Besides, studies after studies have shown that even experts have a mixed record when it comes to being able to predict near-term movements of stocks and markets.
Why Timing the Market is a Difficult Proposition
Given below are some reasons why investors find it difficult to consistently time the stock markets:
- High Probability of Failure
Market timing involves two decisions - when to enter the market and the other is when to get out.
In theory, there is a 50% chance of getting one decision right. By consequence, the probability of getting both decisions right becomes 25%. As a result, the odds are stacked against investors who frequently trade in and out of stocks.
- Consistency is Impossible
Often times, investors get carried away during runaway bull markets, when even blind bets on the market prove to be correct. However, the mistake of confusion luck with skill is committed by many investors. They forget that a rising tide lifts all the boats.
Timing the market consistently is near impossible. For instance, many traders target, and during a winning streak, make 5-10 percent return a month. This adds up to a compounded annual return of between 70 and 130 percent. Meaning somebody starting with a capital of Rs 1 lakh could grow it to Rs 404 crore in 20 years. While technically possible, it is not possible to make such a high return consistently.
- Costs
Investors who believe in timing the stock market are the favourites of brokerage firms. The more stocks they buy and sell, the more commission these firms generate. However, this commission is paid from the investor's wallet regardless of whether he or she made a profit or loss. Moreover, taxes on profits generated by short-term trading are higher than tax on long-term gains. This means that costs and taxes will almost always set you back.
The Right Way Of Investing
Indeed, the stock market is the best way to grow your income. However, it is only possible when you invest mindfully and for the long term. Here is what you should do to invest in the right way:
- Research — This is the main requirement for earning profits from the stock market. Research well about the company, stock, bond or any other instrument you're investing in. Look at their history, performance, factors, etc., before making any final investment.
- Follow the advice of an experienced financial advisor. A good advisor will help you take decisions that matter more for your success – such as staying put during difficult times instead of making frequent moves.
- Have patience, and don't let your emotions (greed, panic, excitement, fear) drive your investment decisions.
Does everything we have said means that you should never try to time the market? Timing is something that should be avoided by most investors.
However, as legendary investors like Warren Buffett have shown, serious wealth is made by taking a contrarian approach. This means being greedy when others are fearful, and fearful when others are greedy. By definition, only a small section of investors will be able to do this successfully.
A good way to time the market would be to follow a quasi-timing approach. This means that you should invest consistently – perhaps in the form of an SIP – so as to not miss out on any big upward movement in the market. But should the market fall sharply as it does once every few years, you could back up the truck and load up on great companies that are trading at a discount.
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