A New Reason Investors Shouldn’t Try to Time the Stock Market

Moving in and out of stocks not only lowers returns, it adds to volatility, according to a new study
Shlomo Benartzi

Researchers have amassed plenty of persuasive evidence in recent years showing that market timing—or moving in and out of stocks based on where you think the market is headed—often leads to lower returns.

But if that isn’t enough to convince you, perhaps this will: A new study finds that active trading also significantly increases the volatility of a portfolio. That is, market timers actually assume much more risk to get those lower returns, compared with investors who simply buy and hold investments.

These findings are timely, following a year in which the stock market took investors on a wild ride, plunging into a bear market early on and then surging to record highs at year’s end. Over the same time, digital apps that encourage Americans to engage in active trading strategies also experienced explosive growth as new investors—some likely stuck at home because of the pandemic and seeking new thrills—crowded into the market.

So as we enter a new year, and investors are forced to deal with a future full of uncertainty, it is worth looking at this new study from Ilia Dichev of Emory University and Xin Zheng of University of British Columbia that explores the connection between active trading and risk.

Although active investors tend to “chase stability”—they are trying to minimize volatility by market timing—they end up doing the exact opposite, according to the research, as they invest in stocks after past volatility is low and before future volatility is high. The end result is high capital exposure when volatility is increasing. In particular, Drs. Dichev and Zheng find that “the volatility of the actual investor experience is nearly 50% higher than the corresponding volatility of stock returns.”

The professors also find that the increase in volatility grows over time. For example, a typical investor with a 30-year investment horizon experiences a 71% increase in volatility, at least relative to those who just buy and hold investments.

The link between market timing and increased risk appears to be a global phenomenon. Drs. Dichev and Zheng find a similar pattern in a variety of international markets, including Canada, Germany, Japan and the U.K.

Their findings reveal the full cost of active trading. Such investors are chasing safe winners, but they’re actually getting risky losers. This means that active investors, on average, assume much more risk to get lower returns.

So why do so many individual investors continue to engage in active trading and market timing despite evidence showing it is often counterproductive? Researchers who have explored this question suggest that some investors—particularly men—are convinced the results don’t apply to them. Others simply enjoy playing the market; trying to pick winners is more fun than sticking with long-term investments, probably for the same reason that many people enjoy blackjack and slot machines.

That became apparent over the past year as individuals, many of them new to investing, flocked to online trading platforms to try their hand at trading stocks. How big have these platforms become? By studying service outages, Brad Barber of the University of California, Davis, and colleagues conclude that activity on Robinhood Markets Inc.’s platform, which allows users to trade securities like stocks for free, now accounts for roughly one-third of all retail trading volume in the stocks that are most popular among Robinhood users.

Critics have suggested one reason these apps might be so popular, and generate so much active trading, is that they gamify the investment experience, appealing to sensation-seeking investors. For instance, Robinhood updates stock values within the app every few seconds—the changing numbers even spin like a slot machine. When investors take certain first actions, confetti falls across the screen in celebration.

Alas, the evidence suggests that more trading often leads to worse results, both in terms of volatility and returns. Dr. Barber and colleagues, for instance, show that Robinhood investors are more likely to engage in herding, which leads to short-term price spikes and longer-term price declines. Within a month, the most popular stocks on Robinhood tend to decline between 5% and 9%. One likely reason is that short-sellers often bet against those same stocks.

In response to such criticism, Robinhood says its platform, which was built for mobile-first customers, has expanded access to the financial system and enabled millions of people to learn and invest responsibly.

“We see evidence that most Robinhood customers use a buy-and-hold strategy, and research published by the National Bureau of Economic Research found that Robinhood customers acted as a market stabilizing force through market volatility in 2020,” a spokesperson for the company says.

Still, research from Dr. Dichev and others suggests that making trading easier and more exciting is likely to backfire for most investors. Instead of celebrating the activity, we should be encouraging investors to stay focused on the long-term. We should show them confetti for not trading.

We’re living through a period of high volatility, both for the world and the financial markets. However, one proven way to make your investments less volatile in the new year is to do as little as possible with them.

Dr. Benartzi (@shlomobenartzi), is a professor and co-head of the behavioral decision-making group at UCLA Anderson School of Management and a frequent contributor to Journal Reports. Email him at reports@wsj.com.

The Wall Street Journal