The blindfold and the buy and hold: Why market timing should not be dismissed

There’s a classic saying that you should never discuss politics, religion, and sex at the dinner table. After nearly a year of investment blogging, I’m of the mindset that market timing should be added to that list as well.

When I began studying investing, two of the first books I read (on the recommendation of personal finance blogs) were A Random Walk Down Wall Street and The Little Book of Common Sense Investing. They were both well written books that did a very good job introducing investing to me. They both also shared a common philosophy: It’s a fool’s errand to try to beat the stock market. Give up now and try your best to mimic it.

Most conservative investors push two main concepts: First is to never buy individual stocks, and second is to never try to time the market. I have written about both here, but it’s the second I would like to focus on in this post, spurred on by an article in the Wall Street Journal today entitled Stocks Tarnished by Lost Decade. In brief, the article says that money invested in an index fund nine years would be in nearly the exact same place today, even less when taking into account inflation.

Supporters of the buy and hold philosophy like to say that market timing is risky. It’s funny, because I think the exact opposite: Staying in your investments no matter what is happening in the market seems ludicrous! I’m in the middle of a book called How I Made $2,000,000 in the Stock Market by Nicolas Darvas, and he has a great little paragraph on this:

I could, of course, have bought these stocks and “put them away.” This is a classic solution among people who call themselves conservative investors. But by now I regarded them as pure gamblers. How can they be non-gamlbers when they stay with a sotkc even if it continues to drop? A non-gambler must get out when his stocks fall. They stay in with the gambler’s eternal hope of the turn of a lucky card.

I work at an investment advisory service that practices market timing. For nearly four decades they have beat all the market averages. In late 2007, they advised moving heavily in cash, and are now doing almost three times better than the S&P 500, and four times better than the Nasdaq.

Yesterday, I went down to the archives room and leafed through their monthly newsletters from 1987. As each month passed, they advised moving more and more money out of the market – right in the middle of a massive bull market. Three days before Black Monday, their headline was “REMAIN IN THE STORM CELLAR.” Buy and hold investors watched their profits from the past year completely wiped out three days later.

The most often quoted “fact” I hear about buy and hold is that if you missed the best X days in the market, your portfolio would be down X percent. This is an argument chock full of holes, such as:

Missing the worst ten days would have profited you three times as much as missing the best days (source)
Most of the best days are followed by the worst declines, wiping out those huge numbers (source)
All but two of the “best” days occurred in the 2000-2002 bear market (source)

Next these arguments are followed up by a slew of quotes from famous investors. Of course, there are just as many famous buy and hold investors as there are market timing investors, so it’s a logical fallacy to cherry pick the quotes that agree with one side of the other. But let’s take a look at one of the most famous and successful investors of all time, Warren Buffett, on market timing:

In a USA Today interview some years ago, Warren Buffet was asked what he thought of the “buy & hold” strategy as a viable strategy for the less sophisticated stock market investor. He said in short that it was absurd. He went on to name a long list of companies, most of their names were household words, whose stock price had collapsed 20 years ago and had yet to recover.

He summed up his warning to would-be buy & hold investors as follows. If you want to buy and hold stocks, you had better have a buy & hold portfolio. He went on to explain that unless you had real bargains to begin with in your portfolio, the odds of time making you whole were low at best.”

Part of the “problem” with market timing is that there is an actual strategy to it. The buy and hold strategy is simple. Market timing can be incredibly complex, so it is important to follow a system that works – or follow an analyst who uses a good system.

Unfortunately, due to both credibility and privacy issues, I cannot say the name of the service I work for. But there are services such as Hulbert which monitor the performance of investment advisory services, many of which practice market timing.

8 Comments so far

Even Warren Buffet admits he has no idea what the market is going to do. And most ordinary people just don’t have access to sophisticated market analysis. And often, sophisticated market analysis is just plain wrong.

“Buy and hold” doesn’t mean “invest without any thought at all.” Even advocates of the “buy and hold” strategy don’t recommend buying stocks and blindly holding them. They most often recommend buying a mutual fund and holding it. Certainly, if you bought, say, ten specific stocks, you should re-evaluate them periodically to make sure the companies are still worth owning. And if you hold index funds, you should periodically re-evaluate and rebalance if, say, your International stock index fund has gotten to be a larger percentage of your portfolio than you expected. That’s a good way to avoid busts — if you re-balanced your portfolio in 2001 to make sure tech stocks weren’t a huge portion, you could have avoided some of the effect of the bust.

[...] Jon from The Money Mythos presents The blindfold and the buy and hold: Why market timing should not be dismissed. [...]

“money invested in an index fund nine years would be in nearly the exact same place today”

This is false, as it excludes dividends:

http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?Country=USA&Symbol=VFINX

Sorry, my link to my source wasn’t working correctly. But it is now, and if you check it you’ll see that the study does include dividends.

Just a brief glance shows that index fund gained 3.43, about matching inflation. Also, that’s for 10 years, not 9, which I believe is the metric they used.

I enjoy your blog very much, and have found a lot of useful advice on it. So i commend you for this, but i have to disagree strongly with this article, especially with your incorrect portrayal of warren buffets stance on the issue. In fact, Buffet himself is a major practitioner of buy and hold (although he has bragged at times that he could buy and sell proficiently, he has made his money with buy and hold almost exclusively). A few of his quotes:

Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

As far as you are concerned, the stock market does not exist. Ignore it.

and, perhaps best:

Always invest for the long term.

and:

Buy a business, don’t rent stocks.

aggregated on http://beginnersinvest.about.com/cs/warrenbuffett/a/aawarrenquotes.htm

And one last one, found today on thefivecentnickel:

“I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.” - Warren Buffet

What you are saying is so true. But, i still believe you can beat the market. How is the part thats hard. I personal do not believe that we should living with living with a beta of 1.

Thanks for the comments! I always appreciate it when my posts generate discussion.

Regarding Warren Buffet, the main point that I was trying to make is that nearly every time market timing is attacked, some quote from Buffet is invariably brought out to defend buy & hold. It’s almost as if just mentioning Buffet’s name is enough of a defense! While he is undoubtedly one of the most famous and successful investors, because of the fact that he often promotes buy & hold, most people seem to think that this is the other option.

Yes, we know Buffet is a proponent of buy & hold (though my quote in my post shows that he acknowledges its limitations). And yes, we know it worked for him. What a lot of people don’t seem to recognize though is that buy & hold is not the only viable strategy - it’s just the easiest and most popular.

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