The myth of the market crystal ball
Trying to predict market swings usually results in buying and selling at all the wrong times.
NEW YORK (Money) -- Question: I'm in an 85% stock mix and thinking about moving my 401(k) dollars to a preservation type of fund. I predict a continuation of the downward trend in stocks over the next year. Should I get more conservative?
The Mole's Answer: It's hard to recommend an asset allocation for you without knowing anything about you, but from your question alone it appears that you are too heavily invested in stocks for your psychological comfort level. I can definitely tell you that you are considering a change for the wrong reason.
You said you predict a "downward trend in stocks next year." Let's explore this a bit.
I give investing presentations to groups and always ask the group a few questions. One of these questions is what return they expect from the stock market. For the last couple of years, I consistently got responses of 15% to 20%, and even the most pessimistic responses were still a positive return.
Today, I'm more often than not getting responses with negative returns with even some of the optimistic predictions at a loss. So what gives?
Well, we can chalk this pessimism up to a phenomenon known as recency bias. This is a human behavior that leads us to place far more weight on what has happened recently than what happened years earlier.
For instance, a year ago we were solidly in the five-year bull market and feeling pretty good about things. The pain of the 2000-2002 bear market was a distant memory. A recent Money column asked Are you really such a daredevil? This column posed that question at the right time, when the market was hitting new highs.
Now that the stock market is down, daredevils are pretty hard to find. Fear and pessimism have taken over, even though we logically know the market is a better buy today than it was last October.
Our impulse to dial it back and get more defensive in a bear market can be traced back to those pesky emotions that insist on working against us. They make us masters of predicting the past and keep us systematically buying high and selling low.
Predicting the future
I can't tell you for certain that your prediction for the coming year is wrong. But I can tell you that there are two types of people when it comes to forecasting short-term market performance:
Those who don't know how the market will perform next year.
Those who don't know they don't know how it will perform.
I suspect you have been listening to the gurus in the second camp. They also do a great job of predicting the past and seem optimistic after an up market and pessimistic during a down one.
I suggest you do two things:
1. Pick an asset allocation and stick to it for the long-run. If you don't need the money for 10 years or more, then you can probably have a high allocation to stocks, if you can stand the pain of a down market without panicking and selling. But if you're going to move in and out of the market, then you may actually be better off in money market funds. That's because your penalties for trying to time the market are likely to take from your return and yield less than an FDIC insured money market. One of my favorite sayings is "if you can't be right, at least be consistent." Sticking to your asset allocation may be more important than picking it in the first place.
2. Rebalance periodically. Market swings can throw off your allocation. So to stick to your selected mix, you might need to do some portfolio housecleaning. There is a systematic way to boost your return by buying low and selling high. Whatever allocation you pick, periodic rebalancing will ensure you sell some of your stock funds in an up market, and buy more in a down one. This is a far better way to invest, though not an easy one. It takes nerves of steel to overcome our instincts and to buy something disappointing, and sell something that has brought us pride and pleasure.
My advice: Give up on the illusion that you or anyone else knows what the market will do next year.
I think you'd be far better off in a 50% stock portfolio, and staying there, rather than being 85% in the market one year and completely selling out of it the next. The more you try to outsmart the market, the more it outsmarts you, and the lower your returns are likely to be.
The right time for a conservative portfolio
When it's time to dump your broker
Where to invest for the short term
More from the Mole in Money Magazine:
Truth or dare for your financial adviser: Put your prospective planner's frankness to the test with these four tough questions.
When to tell your planner you'll sleep on it: Why you shouldn't rush to act on advice, no matter how good it sounds.
Retirement: How much you'll really need: Sure you could live more cheaply in retirement. But some costs will go way up.