Goal Planning vs Market Timing
What is market timing?
Market timing is when investors try to predict market movements and try to time their purchase and sale trades in different stocks. The investor aims to enter/invest at the lowest price and exit/sell at the highest price and maximise his/her profits in the process. But, does it really work? In this article, we will discuss goal planning vs market timing and see which one works.
If you ask most investors one wish they would like to fulfil, they would say getting the market timing right. But, despite the best qualification, experience, and using the best tools available, most investors who try to time the market don't get it right most of the time. Hence, for most investors, this wish remains on their wish list.
(Source: naturalbridgesfa - what-happens-when-you-fail-at-market-timing)
The above image shows the difference between spending time in the market and market timing. Let us assume that an investor invested $1,000 in the S&P 500 index on 1st January 1970. This is how his/her investment returns will look like if he/she stayed invested till 31st August 2019 or tried timing the market with entry/exit at various price points.
- Spending time in the market: If the investor stayed invested for the entire period, the $1,000 investment would be worth $138,908, multiplying the investor's wealth by 138 times.
- Market timing (missing the S&P 500's best-performing day): If the investor tried to time the market and in the process missed the S&P 500's best performing day, then the $1,000 investment would be worth $124,491 instead of $138,908
- Market timing (missing the S&P 500's 5 best days): If the investor tried to time the market and in the process missed the S&P 500's 5 best days, then the $1,000 investment would be worth $90,171 instead of $138,908
- Market timing (missing the S&P 500's 15 best days): If the investor tried to time the market and in the process missed the S&P 500's 15 best days, then the $1,000 investment would be worth $52,246 instead of $138,908
- Market timing (missing the S&P 500's 25 best days): If the investor tried to time the market and in the process missed the S&P 500's 25 best days, then the $1,000 investment would be worth $32,763 instead of $138,908
The above example clarifies that an investor should focus on spending time in the market rather than timing the market. Trying to time the market may result in missing the best investment opportunities leading to lower returns.
Chart: Sensex chart for the calendar year 2020
The investment decisions of most people who try to time the markets are guided by the two emotions of greed and fear. The above chart shows the Sensex journey from 1st January 2020 to 31st December 2020.
An investor would have panicked by the direction of stock markets and withdrawn their funds in March 2020 at the bottom. This would have led them to completely miss out on the rally and growth that came after.
Pitfalls of market timing
The markets are volatile by nature. Hence, it is simply not possible to time the markets. Let us understand why market timing fails for most people with a simple example.
Let us say Infosys is going to declare quarterly earnings results in the 2nd week of April. There is a rumour that it is going to announce a strategic acquisition along with the results. You decide that you will buy Infosys shares after the results are declared. The stock price of Infosys has already gone up 10% in anticipation of good results and acquisition news from the start of April.
As expected, Infosys declares good results and announces an acquisition, and you buy Infosys shares. Post your purchase, and the stock price corrects 5% after the reported results and acquisition announcement are in line with expectation. The stock price correction is contrary to your expectation of the stock price going up. But, you need to understand the stock price had already run up 10% in anticipation of this news. It is a classic case of "buy on the rumour and sell on news". In the process of trying to time the markets, you lost money instead of making money.
Market timing decisions are guided by greed and fear
When attempting to time the markets, many retail investors are driven by greed and fear. In this process, they get their timing wrong and incur losses. For example, when the markets areising continuously, many retail investors get carried away by the frenzy and start investing at high valuations. Their investment decision is driven by greed. As valuations enter a bubble zone, any bad news results in a sharp correction and retail investors lose money. Eventually, they sell at lower levels and book losses.
Similarly, in a bear market, the share prices of a lot of companies fall. This is an excellent time to buy for the long term. But, during this time, the investment decisions of retail investors are held back by fear. They think prices will fall further and hence don't buy. Eventually, the market turns around and starts going up, sometimes pretty sharply, and retail investors once again miss out on entering at reasonable levels.
Goal-based investing: Keep aside emotions of greed and fear
As an investor, if you wish to avoid the common mistakes of investing when markets are high and selling when markets are low, you need to keep your emotions aside of greed and fear. You can do this by not trying to time the market and instead of practising goal-based investing.
Goal-based investing is a strategy that is guided by your financial goals. Your focus is on accomplishing your financial goals rather than maximising your returns with market timing. It starts with identifying your financial goals, making plans for them, and pursuing them till they are accomplished.
How does goal-based investing work
The goal-based investing strategy works as follows:
- Identify your goals: The goal-based investing strategy starts with making a list of your financial goals.
- Classifying goals based on duration: Classify your goals into short, medium and long term depending upon the time frame.
Short-term financial goals: Goals that need to be accomplished within a year or so maybe classified as short-term goals. Some of these include building an emergency fund, buying term life insurance for the family bread earner, buying health insurance for the entire family, paying outstanding credit card dues, etc.
Medium-term financial goals: Goals that need to be accomplished within 5 years or so maybe classified as medium-term goals. Some of these include building a fund for down-payment of a house, repayment of vehicle loan, building a fund for annual vacations, etc.
Long-term financial goals: Goals for which the available time horizon is more than 5 years may be classified as long-term financial goals. Some of these include building a fund for children's higher education, retirement, repayment of home loan, etc.
- Risk profiling: After the classification of goals, you need to assess your risk profile. You can do this using the Glide Invest App. You will be asked a few questions about your risk-taking ability. Based on the answers, you will be classified as an aggressive investor or conservative investor.
- Asset allocation: Your risk profile decides your asset allocation. Asset allocation refers to the process of investing your money into different asset classes in varying proportions.
- Making a goal plan and prioritising goals: For each financial goal, the Glide Invest App will provide you with a plan with the details of asset allocation, mutual fund schemes to invest in, the amount to be invested in each scheme. If you realise that you cannot start investing in all financial goals, you can then prioritise your goals and invest accordingly.
- Implementation and regular review of goal plan: Once you start investing towards your financial goals, you need to review every 3-6 months regularly. During the review, you need to check whether your investment portfolio is performing on expected lines. You should make appropriate changes, if and wherever required. You should continue the regular review process for each financial goal till you accomplish the goal.
Goal-based investing and asset allocation
Asset allocation is a critical component of goal-based investing. The asset allocation process involves investing in different asset classes like equity mutual funds, fixed income securities, gold, etc., in varying proportions. The basic premise for asset allocation is that you don't know which asset class will outperform others in the coming years. Hence it's best to be hedged by investing across asset classes. Different asset classes have their cycles of up moves and down moves. Therefore, with appropriate asset allocation, your investment portfolio can benefit from the up moves of one asset class (for example gold), when another asset class (for example, equity) is not doing well. Fixed income can provide stability to your overall portfolio.
Asset allocation is decided on various parameters, including investor's risk profile, age, time to achieve financial goals, etc.
Market timing doesn't work.
In the process of trying to time the markets, most retail investors end up doing the following:
- Either they miss out on investing at lucrative valuations during correction phases/bear markets due to fear, or
- They end up investing during a bubble phase due to greed and incur losses in the correction that follows when the bubble bursts
Retail investors need to understand that even the best of investment experts cannot time the markets. Markets have a mind of their own and don't always behave as per expectation/perception. Hence, market timing is a futile exercise. As famously said by Warren Buffet, "Markets can remain irrational, longer than one can remain solvent."
An investor should always follow goal-based investing that focuses on accomplishing financial goals rather than maximising profits. Goal-based investing is about spending time in the market rather than market timing. Goal-based investing involves asset allocation because it is tough to predict which asset class will perform well in which year.
Finally, we leave you with a famous quote on market timing by none other than Peter Lynch. He says: "I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it."