Thursday, January 3, 2008

Market Timing can be Tempting and Difficult to Avoid

Wouldn’t it be great if you knew when the stock market was going to go down? You could sell your stocks, wait for a while, and buy them back when the stock market was going to rise again. You’d get rich very quickly.

Sadly, there doesn’t seem to be any magic way to know when the stock market will go down. You just can’t predict short-term swings in stock prices. But the sting of watching the value of your holdings drop 10% can make it tempting to look for signs of a market decline. Many people actually do a reverse kind of market timing. They get nervous and sell after stock prices drop, and they buy back in after prices start to rise again.

Many commentators offer the sound advice that you should keep saving money and ignore short term stock market swings. Suppose that you have taken this advice to heart. Maybe you pour savings into low-MER index funds every month without thinking about whether stocks are up or down. Even so, you will still be forced into a situation where it will be tempting to think like a market timer. Let me explain.

At some point, you will have some use for your money. Suppose that you’ve been saving for 15 years for your child’s college education, and you’ll need some of the money in 3 years. Maybe you’ve heard the sound advice that you shouldn’t have money in stocks if you’ll need it in less than three years. So what should you do?

You could sell enough stock right away to pay for your child’s first year at school, but what if the stock market is down right now? It is very tempting to try waiting for the stock market to recover before selling. You are being pushed into a market timer’s way of thinking. Just as investors find themselves thinking like traders sometimes, investors are also pushed towards market timing sometimes.

One solution to this problem is to sell a small amount of stock every two or three months that will add up to the amount of money you need in three years. So, you’re selling stock the same way you bought it; steadily, and without any market timing. As the cash builds up, you could put it into fixed income investments (like bonds) that will come due when you need the money.

It pays to think through your financial plan in advance so that you’re not forced into a situation later where you’re tempted to try market timing.

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