Without doubt, the most serious mistake individual investors make is trying to time the market. Neither individual nor professional investors are able to make consistently accurate calls on the direction of market prices. In fact, I have never known anyone who knows anyone who has consistently made accurate directional bets on either equity or bond prices.
When individual investors try to time the market they are much more likely to buy and sell at the worst times. Emotionally, investors suffer great pain when pessimism is rampant and stock prices fall. They are more likely to buy when everyone is optimistic and prices are near or at their peak. Behavioral considerations cause investors all too often to shoot themselves in the foot.
The evidence is remarkably strong that the behavioral biases described above influence investor behavior. The chart below superimposes data on the flow of monies into and out of equity mutual funds (the shaded histograms) on the 12-month returns of the Standard and Poor’s 500 index (the solid line). (The source of the flow data is the Investment Company Institute.)
Note that when prices are high and returns are good, money tends to flow into equity mutual funds; when prices are low, investors make net withdrawals of funds. In the first quarter of 2000, which coincided with the top of the Internet bubble, more new money was invested in equity mutual funds than ever before. Then in the fourth quarter of 2002, which turned out to be the market bottom after a sharp decline in stock prices, investors pulled large amounts of money out of equity mutual funds. Then, in the third quarter of 2008, during the worst of the recent financial crises when stocks made decade lows, investors redeemed unprecedented amounts of equity mutual funds. Our emotions lead us to sell at bottoms and buy at tops.
Several empirical studies have tried to measure the cost of bad timing decisions. They all agree that investors tend to do much worse than a buy and hold investor who avoided market timing altogether. A well-known study of the so-called “behavior gap” by Dalbar Associates estimates that it may be as large as 5 to 6 percentage points annually over the past 20 years. Other studies have estimated somewhat smaller gaps, but all of the studies agree that harmful investor behavior is extremely costly.
Investors are still their own worst enemy.