The trouble with market timing
Stocks have rallied lately, but that doesn't necessarily mean the bear market is over. Here's the problem with moving in and out of the market.
NEW YORK (Money) -- Question: I'm 57, and after losing several thousand dollars in my 401(k), I transferred my money to a safe mutual fund. But now that the stock market has gone up the last few weeks, I'm wondering: Should I stay in the safe mutual fund or switch some of my money back to stocks? --Heidi, South Lake Tahoe, Calif.
Answer: There's no doubt that stocks have had a powerful rally.
But is this comeback the start of something big? Or a bear-market trap that will lure you in only to whack you with more losses later on?
Therein lies the puzzlement. If you're going to play this game of pulling your money out of stocks to avoid losses in hopes of moving in later to catch the upswing, how do you know when to get back in?
I suppose you could keep close tabs on the market and decide that, once stocks have risen by a certain percentage, you would jump back in on the assumption that a new bull market is underway.
But what would that percentage be?
Set it too low and you get drawn in by false rallies, like the 18% jump in the Dow we saw last year between October 27th and November 4th or the 17% rise between November 20th and 28th, both of which fizzled and were followed by more losses. Set your re-entry target too high, and you miss a lot of the recovery while you're sitting on the sidelines waiting for the market to hit your trigger point.
Another way to go might be to hold off moving back into stocks until you're sure that the economy has turned around. At least that would give you some confidence that a stock-market rally won't be squelched by more bad news on the economic front.
But that strategy is problematic too, since stocks generally rally well in advance of a recovery.
Back in 1973, for example, the economy entered a severe recession and the Dow dropped 45% from the beginning of that year through the end of 1974. Then, as now, there were a number of aborted rallies and investors wondered when stocks would eventually recover.
As it turned out, the Dow rebounded by more than 38% in 1975. But investors who waited to be sure the recession was over before putting their money in stocks didn't earn anywhere near that return. Why? Well, the recession didn't actually end until March of 1975, by which point the Dow had already climbed 25% for the year. So by missing just the first three months of the market's rebound, an investor would have missed out on roughly two thirds of 1975's huge gains.
In short, I don't think it's possible to know when it's best to get back into the market. And although you didn't ask, I also don't think it's possible to know the best time to get out to avoid losses either.
Which is why my advice to you is to stop trying to time the market with your retirement money and instead focus your efforts on creating a 401(k) portfolio that has enough stocks to give you a shot at decent long-term gains and enough bonds and cash to avoid a huge loss.
Someone in your situation, a 57-year-old presumably closing in on retirement within the next decade or so, needs to be especially careful. Even if you believe the market is on the verge of recovery, you don't want to bet too heavily on stocks. If you're wrong, you could get badly burned, as I suspect was the case with the nearly one in four people between ages 56 and 65 that an Employee Benefit Research Institute study found had more than 90% of their 401(k) balances in stock at the beginning of last year.
Play it too conservatively, on the other hand, and your portfolio might not earn enough to support you comfortably over a retirement than can last upwards of 30 years.
There's no single "correct" stocks-bonds mix for someone your age. That will depend on the size of your account, how much income you'll need to draw from your nest egg, what other resources you have and how comfortable you are with your portfolio's value going up and down.
But you can get a reasonable estimate of what might make sense for someone your age by consulting the stocks-bonds allocations for the target-date retirement funds on our Money 70 list. You can then check out a tool like Morningstar's Asset Allocator to get an idea of how a specific stocks-bonds mix might perform. (Emphasis on might here. There are no guarantees when it comes to stocks and bonds.)
As you get older and require more stability in your portfolio, you can gradually shift more of your money into bonds and cash. But you want to avoid making dramatic moves in or out of any asset class because of a hunch about what might happen.
I can't promise you that setting an appropriate portfolio mix will shield you from all losses or definitely yield the highest return. But a systematic approach is a better way to go than playing the guessing game you're engaged in now.