Trying to time the market is a losing game
Some people spend their entire investing lives trying to time the market in an attempt to buy at the low and sell at the high. Others try in a moment of emotional decision making when the market is in chaos or on a bull run.
You have to be right twice (when to buy low and when to sell high), and it’s hard enough being right once, much less twice. This is virtually impossible, unless you have a crystal ball, which does not exist. It’s kind of like trying to predict what the weather will be on a specific day two months from now. No one knows .
You see even more of this going on when the market gets volatile. People begin to panic or get greedy and they start trading based on emotions, which almost never ends well.
I cringe when I hear someone say that the market is going to crash soon so you should move to all cash until things get better. This thinking is too binary. 100% cash or 100% stocks are not your only choices. It’s a losing game to try to play it that way.
There is a simple process to buy lower & sell higher
Rather than attempting to achieve the impossible, instead there is a systematic process you can follow to ensure that you are buying lower and selling higher. You won’t be selling at the peak or buying at the trough (no one else will consistently either, regardless of the method), but you will consistently be buying lower and selling higher.
It’s just a function of how the process works. This is probably one of the most critical tenets of successful investing, along with diversification.
The simple process is rebalancing your portfolio!
Let’s say, for example, your portfolio is 60% stock index funds and 40% bond index funds as you have determined that this is the correct mix based on your risk tolerance and financial goals. The percentages will vary by investor based on your individual risk tolerance and where you are at in your investing cycle (more aggressive or higher equities when younger or further from your investing goal and more conservative and lower equities when older or closer to your savings goal).
One rule of thumb is using the formula: (110 – your age) to determine your equity percentage. This assumes you plan to retire around age 65. For example, if you are age 50 you would calculate 60% stocks (110-50) which leaves 40% bonds. This is just a rule of thumb but gives you an idea of a stock / bond mix.
Regardless, let’s assume also that you have $1,000 invested which would make the split $600 stock funds and $400 bond funds.
Using this example let’s say, a year later, due to a run up in the stock market, your portfolio is now worth $1,200 with the split of $800 in stock funds and $400 in bond funds. That calculates out to 66.6% stocks and 33.3% bonds, which is now different than your 60%/40% determined ratio.
So, getting back to your desired split would have you change your investment mix to $720 in stock funds and $580 in bond funds (back to 60% stocks and 40% bonds). That would mean you would sell $80 in stocks and buy $80 in bonds. This is called rebalancing.
You would rebalance periodically (say once every year or two). By rebalancing in this case you would be selling some of your stocks that are higher (taking profits while prices are higher) and buying bonds. In other words, taking some profits to rebalance your portfolio.
Conversely, let’s assume the original example of $1,000 invested with $600 stocks and $400 bonds at the desired 60%/40% split. A year later, your value is now $800 with $420 in stocks and $380 in bonds. This is because the market had a significant drop. In order to get back to your 60:40 split you would then buy $60 in stocks and sell $60 in bonds to get to $480 in stocks and $320 in bonds. In this case you are buying stocks lower.
By doing this you are taking all the emotions out and following the rebalancing percentages! Many investors let emotions get the best of them and who can blame them, as we are human and when the market drops the last thing we want to do is buy.
If you just follow your determined mix and rebalance once a year you buy lower and sell higher and you keep the risk tolerance mix that fits your investment strategy.
What About Taxes?
Does’t rebalancing create a tax liability by selling shares? Yes, if in a taxable account. If in a retirement account (401K or IRA, for example) it won’t. However, my opinion is to not let taxes keep you from making sound investment decisions. In other words, “don’t let the tax tail wag the dog.” Why would you keep an out of balance portfolio to save a little on taxes? That doesn’t make any sense to me.
Often you can perform your rebalancing in your retirement account which would not be a taxable event.
Target Date Funds Do the work for you
One way to do rebalancing is to invest in a “target date fund.” These funds at low cost providers like Vanguard, Charles Schwab or Fidelity will do two types of rebalancing. First, they will rebalance regularly to keep the stock and bond mix desired in the portfolio. Second, they will adjust the desired mix every year toward the “target date” of the fund. In other words, you can “set it and forget it.” This is a good option for those that don’t want to do the rebalancing themselves.
- Trying to time the market by going 100% stocks or 0% stocks is very risky and impossible to achieve. Don’t fall into the trap of thinking you are smarter than the market.
- Rebalancing annually back to your target mix of stocks and bonds is a consistent method of taking profits as prices go higher and buying when prices go lower
- Rebalancing takes the emotions out of investing. If you follow the target mix you will make much better decisions than most investors
- Emotions are a huge detriment to most investors which often prompts investors to sell lower (panic selling) and buy higher (bull run euphoria) which is the opposite of what you really want
- Target date funds are another way to put rebalancing on auto-pilot
Related: The Four Pillars of Investing by William Bernstein