Market Timing Your Retirement Accounts? Don’t You Dare!

I have a good friend and former colleague who I meet up with about once a month. He’s a pretty sharp guy – he has his CPA and works in the mutual fund industry. Most of our conversations are centered on family, work, and what else we would be doing if we did not have to work!

During our most recent rendezvous, the subject of retirement savings came up. This was not the first time we had discussed how our 401k’s were doing or what we thought of the market outlook in general. This time around he dropped a bombshell. He informed me:

“I have this bad feeling. I think the stock market is headed for a deep drop. I shifted most of my 401k assets into cash. I am now sitting at 70% cash.”

My first reaction was to do a double take and, before I could think of a polite way to phrase my response, I blurted out:

“You are crazy! Market timing in your 401k is a horrible idea!”

What is Market Timing?

According to Wikipedia, market timing is defined as “the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements.”

Market timing does not mean you buy or sell a particular stock or mutual fund because you think it’s headed up or down. Rather, it means you sell across your entire portfolio because you believe the market/economy is going to tank. The hope is then to buy right as the market bottoms out.

In theory, anyone employing a market timing strategy could stand to make a fortune. You would always be buying low and selling high. In essence, you would skip all the downturns by jumping out of the market only to get back in (buy low) when it bottoms out. Then you would ride the wave back up (to sell high).

It sounds great – in theory. In reality, it is a risky investing approach that is almost impossible to make a winning strategy.

For retirement investment accounts like your 401k, Individual Retirement Account (IRA), or your Roth IRA, market timing is an especially scary strategy.

Why Market Timing in Your Retirement Accounts is Bad

Market Timing Not Usually Successful – Even a blind pig finds an acorn once in a while. Similarly, market timing can occasionally pan out. The odds are vastly against it though. A Forbes article on market timing explains it well:

“Successful market timing requires two correct decisions: when to get out and when to get back in. Guessing right once is a 50/50 proposition. Guessing right twice drops the odds to only 25 percent. One wrong guess and you shoot yourself in one foot; two wrong guesses and you shoot yourself in both feet. This is what makes market timing so difficult.”

There are two basic types of market timing. Market timing decisions can based on either or a combination of:

1. Technical/fundamental analysis

2. Emotions

The Forbes article goes on to say there are:

“two types: intentional timing and unintentional timing. Intentional timing is based on fundamental and technical factors to determine when asset classes are attractive and when they are not, and then bets are placed accordingly. Unintentional timing is behavioral – it’s rooted in a natural fear and greed mechanism that we must learn to control.”

My friend who now has his 401k 70% invested in cash did go on to partially explain his rational which is based on fear, not greed. He believes quantitative easing has the economy propped up on a false foundation and, combined with the recent economic issues in China, the US is headed for another big recession. Fair enough. Unfortunately, market timing a 401k is not the solution!

Let’s get to the heart of the matter. Whether you are basing a market timing decision off hardcore analysis or pure emotions – you are almost certainly throwing away some of your returns! Citing Thinkadvisor:

“An array of behavioral finance studies indicate that emotional investing costs the average investor from 2%-5% of their balances per year over the last 20 years … and this is generally regardless of socioeconomic status or smarts.”

It is just too difficult to know precisely when to sell and when the market bottom occurs. Even those relying on technical analysis often miss the target and forfeit returns. That 2%-5% can make a whopping difference when you factor in the power of compound interest.

Long Term Horizon – Unless you are nearing retirement age, the investment horizon in your 401k, IRA, or Roth IRA is extremely long. If you are within perhaps 10 years of retirement and you fear a huge economic meltdown then shifting some retirement assets into less risky investments may be prudent. I would argue that 10 years left is still a bit too early. In any case, if you are not going to retire for another 15, 20, or 30+ years then you should not worry about a bad year or two in the market. Keep in mind any money that you “lose” in your 401k, IRA, or Roth IRA is unrealized. Losses are not realized or “locked in” until you hit retirement and start withdrawing funds.

Think about it this way. Through the end of 2014, the 25-year annualized return of the S&P 500 is 9.62%. That is a pretty nice return. Let’s say you felt uneasy back in late 2006 about the state of the economy and the housing market. You moved to mostly cash in your retirement accounts at the beginning of 2007. You miss 2007’s S&P 500 return of 5.49% (this return rate assumes dividend reinvestment), but that is ok because you completely avoid 2008’s disaster where the return was -37.00%! Unfortunately, your fear has not subsided and you continue to stay out of the market. Oops! The 2009 return was 26.46%. You are tempted to get back in, but you think it’s just a temporary blip back up because the economy is still struggling and there are massive amounts of foreclosures in the housing market out there. So, you stay out and miss the 15.06% return in 2010. You finally get your retirement accounts back into non-cash assets in 2011 only to receive a 2.11% return.

Though this example is a bit exaggerated, it should be pretty obvious that trying to guess the bad years means you may miss the good years.

Buy Low – You have heard of the expression “buy low, sell high,” right? This mantra is no different when it comes to retirement saving. If the market drops then take advantage of the opportunity to buy low! Start pumping more money into your retirement savings if you can. Max out your 401k to get the added bonus of reducing your current period income taxes (the current yearly maximum contribution to a 401k is $18,000). Or, beef up your Roth IRA contributions to the maximum (of $5,500) and watch your earnings grow tax free! Do both if you can!

What You Should be Doing in your Retirement Accounts Instead of Market Timing

You should make all efforts to avoid the perceived allure of market timing in your 401k or IRA. Yes, a possible upcoming market plummet can be worrisome and the economy heading into a recession can be fear inducing. It can be a natural reaction to want to pull your money out of your retirement accounts.

Instead, you need to periodically focus on re-assessing and rebalancing your retirement account portfolio. You should be doing the following:

Re-assess – are you invested in mutual funds, stocks, or bonds that are underperforming? Is there a better investment option now available to you? You should occasionally re-assess your retirement portfolio and optimize as needed. Remember, this is not based on market timing. It simply ensuring you are invested in the best manner and properly diversified.

Re-balance – You should slowly shift toward less risky assets as you near retirement. Doing so provides some insurance against a prolonged market downturn. This is not market timing per se. Rather, it helps to protect your nest egg against market volatility when you are approaching your retirement milestone and thereafter.

What are your thoughts on market timing in your retirement accounts? Would you ever consider trying it? If you have, what happened?

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