Why Market Timing Doesn’t Work for Most Investors
Trading is an exciting game. It’s a thrill to jump in and out of positions. But market timing doesn’t work for most investors. At least if your goal is to outperform the market.
To understand why this holds true, I’ve broken my argument into two compelling explanations. First, I’ll explain why the odds are stacked against retail investors. And second, we’ll dive into some unique psychology that holds back traders.
I do want to be clear, though. You can outperform with market timing. Especially if you have the right strategy. I’m not saying otherwise. But the odds are stacked against you…
Market Timing Is a Zero-Sum Game in the Short Run
In the short run, the market is a zero-sum game. For every buyer, there’s a seller on the other side. Each trade nets out to $0. That being said, trading fees and market makers cut into the trade. And this makes trading worse than a zero-sum game for retail traders.
Thanks to technology, trading fees have, thankfully, come down. But market makers still take a small cut. This usually part of the difference between the bid and ask prices. And if liquidity is low, the bid-ask spread can be wider, and that can lead to a larger cut.
If you trade often, these overlooked fees add up and put the average retail trader at a disadvantage.
On top of that, retail investors are up against institutional investors. These big firms hire some of the best minds in the world. They create trading systems to take advantage of market inefficiency.
These can come in the form of high-frequency trading, which shaves pennies off trades. Some hedge funds and firms are spending billions to trade automatically and move trading data faster…
Lowering the transmission time of trading data by a fraction of a second can lead to millions in profits simply due to scale. This is a direct way to profit on market timing. For example, when the Federal Reserve releases minutes from its meetings, an algorithm could analyze it for keywords and phrases. It could then automatically trigger a trade based on patterns it finds.
Overall, retail investors are up against more knowledgeable and better-financed traders and systems. If you think you can beat teams of engineers and scores of folks with doctorates in math and statistics, more power to you. And once again, it is possible to find a strategy that works. But the odds are stacked against you.
Now let’s look at another powerful force that shows why market timing doesn’t work…
Psychology of Trying to Time the Market
As I’ve already shown you, the odds are stacked against us. But trying to time the market gets even worse…
Our brains have developed to think in certain ways. For example, many people are familiar with our fight-or flight response. But this is just the tip of the iceberg.
We have tendencies that push us to make poor trading decisions. Greed is a powerful emotional state that plays a role. As with gambling, we can get attached to the reward potential and overlook the risk. We seek short-term gratification, and this often comes at the expense of better long-term returns.
Fear is also an emotion that leads to poor trading decisions. When it comes to exiting a position, loss aversion and other psychological pitfalls can lead to lower returns.
When your hard-earned money is on the line, it’s not easy to avoid trading on emotion. But some of the world’s best traders have learned how to avoid it. They take a systematic approach and base their trades on research. This allows them to improve their strategies.
Market timing doesn’t work for most investors, and intelligent investors have taken note. Many of the world’s best investors stick to a buy-and-hold approach. Some of these Warren Buffett quotes explain that strategy.
Another downside of market timing is that short-term capital gains are taxed at a higher rate. If you’re focused on short-term trading and market timing, Uncle Sam can take a bigger cut of the gains.
With all these considerations to factor in, I avoid trying to time the market. But I still like to have a little excitement in my portfolio. So I set a small portion of my portfolio to the side for fun trading. That way I can still end up with some exciting stories… without losing the farm.
Whether you’re looking for long- or short-term opportunities, you might want to consider signing up for Liberty Through Wealth. It’s a free e-letter that’s packed with extremely useful investing tips and tricks. I’ll also leave you with a final thought… in the words of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”
About Brian Kehm
Brian Kehm double majored in finance and accounting at Iowa State University. After graduating, he went to work for a cryptocurrency company in Beijing. Upon returning to the U.S., he started working with financial publishers and also passed the CFA exams. When Brian isn’t researching and sharing ideas online, you can usually find him rock climbing or exploring the great outdoors.