The stock market was going to crash. Of this, Boruch Basch was certain. After a sharp dip at the beginning of the coronavirus pandemic, stocks had quickly reversed. Now, prices were booming with new records being set every day. Even money-losing companies were soaring based on vague claims of tapping into the “new economy.” The euphoria was bound to ebb and the market would tank. Boruch was investing for the long term but why ride an overpriced market down? He figured he’d sell to lock in today’s high prices and repurchase them at a discount after the inevitable bust.

Is this the way to go when the market seems too bubbly?

A Good Theory Falls Short

Getting out of the stock market whenever it has risen to dramatic levels seems intuitively obvious. The problem is that this strategy has been studied heavily and it doesn’t work in real life for the most part. Even if pricing is indeed way out of whack—which it’s not easy to be certain of—bouts of market exuberance and panic often last many years. And knowing only approximately when to get out and then back in doesn’t add much value. In fact, trying to jump in and out of the stock market will generally lose you money. 

Learning From the past

Investors who can consistently sell at market highs and rebuy shares back at market lows will definitely make much more money. But one of the bubbliest markets of all time, the “dot-com bubble,” can illustrate how difficult it is to time the market profitably. In the mid-1990s, the Internet’s becoming a viable mainstream technology triggered one of the greatest stock market frenzies of all time. Virtually any fledgling company that was even remotely connected to the Internet exploded in value, regardless of the likelihood of it actually becoming a viable business. And even the broader stock market rose to prices that were historically unimaginable. 

Dot-com Bubbles and Busts

The annual returns of the US stock market for that time period are listed above. By late 1997, financial commentators were saying that profits driven by triple-digit returns in Internet stocks were unsustainable. But the market kept making fools of them—growing higher and faster than before. It was only years later, in mid-2000, that sentiments shifted and reality returned. From the peak, Internet stocks crashed by 90 percent and the broader market fell with it. Surely this bubble should have been a great time for timing—getting out high and getting back in low. But unless you had impeccable timing, timing the bubble was a fruitless, or even losing, proposition.

Impeccable Crushes Rider

“Mr. Rider”, who simply stayed invested in the market via a diversified index fund for the entire period from 1995–2004, earned an annualized compound return of 12%. His $10,000 invested increased to $30,540, though down from a high of $34,291 at the peak in mid-2000. But this solid return pales in comparison with “Mr. Impeccable’s” 17% return, whose pot grew to $48,530! Getting out for all the three down years (2000, 2001, 2002) and enjoying all the remaining seven up years was very profitable for Mr. Impeccable. (See the chart.)

Hopeful Gets Minimal Gain

Despite this, it’s hard to know exactly the right time to get out and then back in—as noted, the market looked frothy for years before the peak. So, let’s say an investor got out a year too soon and then reentered the market a year before it had bottomed out (i.e., he was in cash for 1999, 2000, and 2001). Even though Mr. Medium rode the market for six of the seven up years and avoided two of the three down years, his net benefit over Mr. Rider was minimal! Being medium provided just a tiny boost to a average annual returns (11.97% vs. Mr. Rider’s 11.81%). 

Chaval al Hazman

So, missing the oomph of 1999 and then getting hit by 2002 leaves Mr. Medium virtually equal to Mr. Rider, despite his being generally correct with his timing. He may have benefited from a bit more peace of mind when his money was in cash, but on the other hand, obsessing over when to get out and back in isn’t relaxing either. The real loser, however, is a fellow who followed Mr. Medium’s path, avoiding 1999, 2000, and 2001 and then reinvesting. But unlike Mr. Medium, who rode through 2002’s downturn, “Mr. Chaval” couldn’t stomach staying in afterward. 

Maneuvering to a Loss

Mr. Chaval jumps out for 2003 and only regains his confidence to rejoin the party for 2004. But 2003 turned out to be a phenomenal year. Locking in 2002’s loss, while missing the next year’s growth (on top of 1999’s) leaves Mr. Chaval’s returns for the decade beneath 9%, significantly less than Mr. Rider’s. (Considering the substantial taxes owed when he locked in gains, he’s actually in even worse shape.) So, while it may have seemed logical and prudent to gauge the market’s levels all these years—the ponderings and maneuvering made things much worse. 

Market Timing Doesn’t Work 

The data is clear. The ability to time the markets correctly on a short-term basis is very limited, even for professionals. Sure, there are outliers—a few traders who can consistently ride the markets perfectly. But these gurus are hard to find and generally won’t accept individual investor’s money anyways! The bulk of the efforts expended by professional money managers is on selecting the most favorable individual stocks, not guessing the short-term ebbs and flows of the entire market. That’s how virtually impossible it is. 

Riding It Out

The majority of investors are therefore best off designing a well-diversified portfolio of mutual funds and then ignoring it for long periods of time. While a market Rider can’t match an Impeccable trader, he does very well against the medium Hopefuls, while far surpassing the Chavals. And the realities of boom-and-bust trader/investors are often much worse than what we’ve modeled here. Someone who only woke up and invested in 1998 enjoyed two years of booming growth followed by three years of crushing disappointment. If you just chase the market, it will probably get away from you.