Reasons Why You Shouldn’t Try to Time the Market

By October 31, 2018Investments

Regardless of whether you are a novice investor or an experienced one, timing the market is a temptation you should really try to avoid. Some people will claim they are able to predict market outcomes and make big investment returns but from our own professional experience, we can confidently say this is incredibly difficult and indeed there are far better ways to invest, in order to protect and grow your wealth.

A Tale of the South Sea

To illustrate our point of view, let us consider the case of Isaac Newton. Notorious for his groundbreaking scientific work, he is perhaps less well known for his role as an investor. Newton witnessed first-hand the growth of shares in the South Sea Company. In January 1720, these shares were trading at nearly £130. Yet 6 months later they had risen to over £1,000.

Sensing an opportunity, Newton invested. Yet he also suspected the rise in share price was unsustainable and decided to sell his stake before it crashed but this did not happen. In fact, the price continued to rise and so Newton decided to re-invest in the same company. It was at this point, as luck would have it, that the share price dived to £175 and Newton’s life savings were virtually wiped out in the process.

Perhaps those close to market speculation such as Warren Buffett with his insight, have a higher probability of success in timing the market but everyone else relies broadly on the same information with very limited knowledge.

Cognitive Biases

We have spent many years working with clients across Kent & the South East, speaking with other financial planners and following stock market investing. We have learned many things along the way, one of them being that people do not always make rational decisions in the world of investing.

Cognitive biases influence people’s investment decisions so the role of a good Financial Planner is to help clients identify and mitigate against their own biases, in order to make smarter decisions for their money. Quite often it takes an impartial, experienced observer to see identify something missing or draw attention to something that is perhaps more important than originally thought.

For instance, one common cognitive bias in investing is called the “bandwagon effect”. In this scenario, you invest in something because everyone else is. This makes the investment look less risky, because we think: “How can so many people be wrong?” Unfortunately, lots of people can all be wrong at the same time. There are countless examples throughout history of dozens of people rushing to invest in the next ‘big thing’, only to see it crash later that day, week or month.

Another cognitive bias is called the ‘gambler’s fallacy’. Just think about the times you have rolled a dice. If you roll four sixes in a row, you might start to believe that a six is less likely to come up if you roll the dice one more time. However, you face exactly the same probabilities as you did for each of the previous four rolls. We can often bring this thinking to our investment decisions. Like Isaac Newton, we might be tempted to sell because our investment has performed so well up until now. Yet, as we say time and time again to our clients “past performance is not necessarily a guide to future returns” in the world of investing.

Emotional Biases

Let us consider two scenarios. In scenario one, someone offers you two choices of either taking a guaranteed £400 home or giving you a 90% chance of taking £500. In scenario two, however, you get a different choice. You can either lose £400 or you can take a 90% chance of losing £500.

What would you do? Most would accept the guaranteed £400 in scenario one and then take the chance of losing £500 in scenario two.

Why does this tend to happen? It is because, broadly speaking, human beings tend to feel loss much more acutely than they do gains. So, if you are not careful, this can often lead to highly irrational, erratic investment behaviour. You might see your investment plummet in a short space of time, for instance, and the emotional loss you feel, drives you to want to sell before things get any worse. Yet this isn’t always the right decision. Sometimes, waiting things out even whilst others are bailing, is the best course of action. It is our job to help you see through this.

Fighting the Chimp Brain

Human beings are highly sophisticated and intelligent creatures, yet there are still parts of our brain that are considered ‘underdeveloped’ or even ‘primordial’. Such parts are known collectively as the Chimp Brain and they tend to exhibit the following traits.

  • Irrational thinking and/or behaviour
  • Decisioning making based on emotion
  • Jumping to a conclusion rather than waiting and weighing things up
  • Paranoid thinking
  • Catastrophizes
  • Seeing things as black or white, rather than shades of grey

With investments, it’s important to recognise this part of our human make up and the best way to deal with these traits is to recognise them when they emerge, put them into perspective, and then set them to one side.