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Are You Trying To Time The Market?

Aug. 20, 2013
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By Michael Philips

Learn more about Michael on NerdWallet’s Ask an Advisor 

Nowadays there are a lot of red flags and alarms being raised out there in financial papers, podcasts, in the blogosphere and various financial websites about the impending “market correction.” There is all this talk about rising risks ahead of a market correction. That the bulls have no more room to run. A lot of podcasts, articles and blogs bombard you with headlines designed to catch your attention such as “Potential Risks Over the Next Two Weeks” and “The Market Hasn’t Pulled Back Yet But It Might Soon” or “What to Expect From the Next Market Correction.” There are a lot of “experts” out there thinking time and time again that they can forecast the market. There have been numerous academic studies and other simulations that have proved time and time again that “no one knows anything” and that market timing is bad for your health. Oh, and definitely your portfolio!

Historically, if one looks back there have been many, many weeks where the S&P 500 or the markets in general have dropped 5%, so it’s actually not that unusual. On a weekly basis, a 10% downturn in the markets qualifies as a correction, and 20% is generally considered going into a bear market.

The average retail investor may also be tempted to move out of equities and into bonds when equity markets gets volatile. There is a common misunderstanding among non-professional investors that bonds are “risk free”. Not exactly. Investors need to be aware of two main risks that can affect a bond’s or a bond funds’ value: credit risk and interest rate risk. In fact, because there is a greater risk of interest rates rising, one should watch their bond holdings, exactly what type of bonds are they holding and maybe trim them to put more into equities. Not all bonds are created equal. In preparation for rising interest rates one needs to look at the “average effective durations” of bond holdings. If you own a bond fund, you can look this information up on Morningstar. The lower the number, the shorter the duration, the better – meaning the less sensitivity to rising interest rates. Basically, duration addresses interest rate risk, a measure of your bond holdings’ sensitivity to interest rates (read one definition of duration here). If interest rates rise by 1% and your average duration is ten, that means the value of your bond holdings will drop 10%. In adjusting your bond portfolio, look for bonds with shorter durations and avoid long term bonds (bonds with a term of 20-30 years).

Today the bull market is turning four years old. The average bull market lasts 3.8 years with the shortest bull lasting 7 months, and a long bull market of 9.5 years between 1990 and 2000.

Time in the market is a more effective and lucrative strategy than timing the market. As countless studies have shown market timing simply doesn’t work. Many consider the best strategy is to stay put with a well-allocated portfolio, aligned with your unique situation, investing time horizon and tolerance for risk. There may be a so called “correction” ahead of us, but nobody really knows anything. This is just media noise. There is a saying that “even a broken clock is right twice day.”

One could be getting out at a 5% or even a 10% drop only to see the market turn around and go into another rally. Considering transaction costs and the nerve-racking engagement and psychological stress that one goes through trying to watch the market and going in and out, it’s simply not worth it; it’s best to hang on.