Sunday, April 7, 2013

How not to market time, and why the EMH isn't a cult.

A student forwarded me this link about the market timing escapades of a couple of individual investors.   Unfortunately the two individuals sold when the market collapsed and then bought back in only after the market had been rising for a while.   Buy high and sell low is not a good trading strategy.

I agree with the author of the article that there are probably many people who are timing the market this way, and suffering the disastrous financial consequences.  But then the author surprised me and went in a completely different direction.

He argues, that the problem is partly due to:
"...the spreading influence of a cult called the Efficient Market Hypothesis, which downplays the importance of the actual price you pay for stocks. It is horrifying how many financial advisers have bought into the nonsense of the EMH, often without even understanding it."
The author states that what investors should do is buy low and sell high.  And the way to figure out when these times are is to follow the old Warren Buffet adage of buying when others are fearful and selling when others are greedy.

Although it sounds easy, this is very hard impossible to do.  For example, today the market is doing really well.  Are people greedy today?   Maybe, but if I sell today and the market goes up another 20%, then I have lost out big time.  What if the market falls 10% tomorrow?  Are people fearful then?  Is that a buying opportunity?  What happens if the following it falls another 20% after I bought in?

It is easy after the event to see when we should have bought and sold, but at any given point in time, we cannot know what the market will do tomorrow or in 6 months time.   This is what the Efficient Markets Hypothesis states.   It doesn't not state the prices are not important.  Far from it, it states that prices incorporate all past information, but they don't tell us anything about the future.   There is no EMH cult, and to say that EMH is nonsense is just silly - the evidence supporting the EMH is vast and very robust.

As always, the conclusion is the same.  You cannot reliably predict future prices and you cannot time the market.   The only solution for individual investors (or any investors) is to pick a risk level that you are comfortable with and then ride the ups and downs of the market.   In the end you'll come out ahead.

HT: John.