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Wouldn’t it be useful to know exactly when the stock market will rise and fall? Having this ability would allow us to sell at the “peak” and buy at the “trough” for each investment, allowing us to get the best returns. Unfortunately, no one has a crystal ball and it is unfeasible to predict what will happen. Given this situation, why do investors still try to “time the market”? Are there any “clues” about how the stock market might behave in the future, even if we cannot be completely certain? What does all of this mean for an investor’s strategy, going forwards?
Why people time the market
Humans are blessed – and plagued – by their psychology when it comes to investing. On the one hand, our rational brains can help us sift through different investment options to find those which offer the best personal risk/reward balance. However, we can also be blinded by our perceptions and emotions. These often lead us to try and time the market even when we know it hardly ever works. For instance, recency bias can lead us to think that an event will occur if it has happened recently in the past. The endowment effect can cause us to believe that an investment is likely to do well because we currently own it, and love it. Overconfidence can cause us to think that we have investment skills that everyone else does not; i.e. we think we can see an opportunity where even professional fund managers are ignorant or blind.
Stock market indicators
Having said this, are there clues as to which direction the stock market may go? Arguably, there are certain conditions in the wider environment that can help drive it up or down. Interest rates can play an important role, for example. If these are set higher (e.g. to control rising inflation), then government bonds (gilts) become more attractive to investors. This can lead investors to abandon their shares for gilts. If sufficient numbers do so, this can cause a crash. Conversely, if conditions in the wider economy are good, these can encourage rising stock market valuations. These conditions might include lower unemployment, a booming housing market and healthy levels of consumer spending.
Implications for strategy
Our inability to predict (and time) the markets has some important applications for an investor’s portfolio. First of all, investors should be very careful about stock picking. Charlie Munger, the business partner of Warren Buffett at Berkshire Hathaway, famously owns 5 or 6 stocks rather than spreading out his investments across 100s of companies. Whilst this may work for those with Munger’s experience, most investors will not have the time, expertise and connections to focus their portfolios on a handful of stocks and stick with them over years (even decades). For most people, it is better to diversify your investments over a range of funds which expose you to multiple companies, markets and countries.
Secondly, investors should also consider their balance of active and passive funds within their portfolios. Active funds are run by fund managers who pick stocks on the investors’ behalf, attempting to outperform market returns. “Tracker” funds, however, simply follows a stock market index – such as the FTSE All Share or S&P 500. This approach is cheaper for the investor since it does not involve employing a fund manager or research team to pick stocks. Rather, new stocks enter the index as poor performers drop out – like a football league, which helps improve the overall quality of the stock “league”. The main drawback of this approach is that the fund will follow the index up and down over time; it will not attempt to “beat the market”. Many investors are unaware that research has shown that following the market in this way usually results in better returns over the long term. WMM’s investment philosophy uses such research and other evidence to give clients the greatest opportunity of a successful investment experience.
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