MISTAKE #1
Market Timing

Boy, do I have an investment for you! It has earned about 10 percent per year over the last 88 years and has gone straight up. Check it out (see Figure 1.1)!

Now, what if I told you that return was real? More intriguing is that it is readily available to you. It's just waiting for you to participate. What is this incredible, magical investment? Well, it's something you may have heard of: the stock market.

If you are like most Americans, this sort of return seems like a dream. Numerous studies attempt to quantify the returns realized by individual investors relative to the market as a whole, and their conclusions are the same: Investors' stock portfolio returns regularly lag behind the stock market return and typically by a very wide margin. Market timing is the idea that there are times to be in the market and times to be out of it. Some people attempt to "protect" their money by exiting the market when they sense a downturn coming or load up on high-risk stocks when they anticipate a recovery.

FIGURE 1.1

Source: Data from S&P Dow Jones Indices, LLC 2014.

Let's get one thing straight right out of the box. Market timing doesn't work. It just doesn't. And don't tell me you don't market time either. Have you ever said or thought anything like this:

"I have cash on the sidelines, and I am just waiting for things to settle down."

"I have a bonus, but I'll wait for a pullback."

"I'll invest after [insert lame excuse here; some choices: the election, the new year, the market corrects, the debt crisis passes, Congress works out the budget, the Lions win the Super Bowl, or whatever]."

All of that is market timing.

Why would anyone want to get in the way of an investment that has perpetually produced such fantastical1 returns?

Quite simply, it is because the stock market doesn't go up in a straight line. Drawn as the returns actually happened, the graph looks like the one shown in Figure 1.2.

That still doesn't look so bad when we look at it from here, with the full benefit of hindsight. Of course, living through it is an entirely different matter. Imagine the emotional turmoil you would have gone through during the Great Depression, the feeling of inertia and futility you would have had to endure through the 1970s, or the market panic during the early part of 2020 (actually, you likely don't need to imagine that one!). With investing, even a few weeks can seem like forever, especially when the market is moving against you.

To be clear, there are many "markets." The graphs we have looked at so far represent the Dow Jones Industrial Average, an index of 30 large U.S. companies with a history allowing us to go back more than 100 years. Today, the more common index is the S&P 500, an index of 500 large U.S. companies, like Microsoft, ExxonMobil, Google, Procter & Gamble, and Apple. While there are thousands of stocks, the largest 500 make up about 80 percent of the entire market. This is because companies like McDonald's, in the S&P 500, are hundreds of times larger than, say, the Cheesecake Factory.2

FIGURE 1.2

Source: Data from S&P Dow Jones Indices, LLC 2020.

Just so no one thinks I am selecting the most awesomest3 investment ever as an example, the same holds for small U.S. stocks, international stocks, and emerging markets stocks. The point is that all broad markets have done the same thing: Go up-a lot.

All of this looks pretty good, right? But to get these returns, you need to avoid making the first big mistake: trying to "time the market." To avoid falling into this trap, it is critical to avoid the many people who are encouraging you to make this mistake: prognosticators on T.V., market timers, your buddy at work, your brother-in-law who "jumped out right before the last crash," and the majority of the financial services industry, to name a few.

This group of market timers can be divided into two camps, as illustrated in Figure 1.3.

Now, that chart isn't scientific. I don't really know what percentage of market timers are incompetent and what percentage are dishonest. However, I believe that market timers fall into one of these two camps, and both are dangerous. Let's take a look at both groups: the Idiots and the Liars.

FIGURE 1.3

Source: Graph by Creative Planning, LLC

The Idiots

What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the WSJ. And, as you read, laugh. We all know that the pundits can't predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven't got a clue.

-Jonathan Clements

There are perfectly honest investors and advisors who believe they can time the market. They believe they know something that no one else knows or that they see something that no one else sees. They often will tell you they got it right before, and maybe they did-once. These folks are often like the friend of yours who tells you "I killed it, baby!" when he returns from Vegas, but conveniently leaves out the five times he lost. They forget their bad decisions and remember their good ones. They may be well-intentioned, but ultimately, they cause harm to their portfolios and to the portfolios of anyone who listens to them. These folks need to get educated and learn the folly of their ways. Luckily, you will soon be able to spot these people, avoid them, and maybe even save them from themselves.

The Liars

There are three kinds of people who make market predictions. Those who don't know, those who don't know what they don't know, and those who know darn well they don't know but get big bucks for pretending to know.

-Burton Malkiel4

Unfortunately, many financial advisors know very well that the market can't be timed, but their living depends on convincing you they can get you out with their "downside protection." This is the easiest sale in the financial advisory world. There is nothing a prospective client wants to hear more than the pitch that they can participate in the stock market's upward movement but avoid the pullbacks. There will always be people who want to hear this, and as long as those people exist, there will be tens of thousands of professionals ready to sell them snake oil.

I have also found that many financial advisors have been exposed to all the information they need to change their point of view away from market timing, but a big paycheck makes it hard to accept the facts. Much like a cult member finding definitive proof their founder is a fraud, the financial advisor can find the reality too much to accept and simply remain delusional and ignorant. As Descarte said, "Man is incapable of understanding any argument that interferes with his revenue."5

The prognosticators in the media also are eager to give you big, bold market calls. I have been on several national business channels, including CNBC and FOX Business. Prior to the show, the producer always asks me for my thoughts on "where the market is going." They are disappointed every time when I answer that over the short run, "I don't know." That doesn't make for the most exciting guest in the world. One national cable network even branded me "The Time Machine" advisor because I kept prefacing my advice by saying I had no idea what would happen in the short run but was very confident about the long run. The graphics were quite amusing, with my head sticking outside of a time machine that looked mainly like an old-school phone booth.6

In short, if you want to get clients and be on T.V., the easiest path is to sell market timing. The financial services industry rewards the deliberate delivery of misinformation.

Why Is It So Hard to Beat the Market?

In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.

-Eugene Fama

There are many reasons market timing fails to work, and there are many reasons investment managers will try to tell you they can do it. Let's start by looking at the big picture, then work our way through the investment gurus and their actual results.

Efficient Markets

The efficient market hypothesis was developed by Nobel Laureate Eugene Fama. This investment theory can be summed up like this: It's tough to beat the market because markets are efficient at incorporating all relevant information. Since a bunch of smart people (and not so smart people) all know the same thing about any given security, it is impossible to have a sustainable edge that will allow you to beat the market return.

Where there appear to be patterns that the market can be beaten, it is almost always due to the investor taking on additional risk. For example, there is evidence that small company stocks perform better than large company stocks over long periods of time, and this is very likely because they are riskier (more volatile).

While it is not my point of view that the markets are perfectly efficient, the evidence is fairly...