Stay Strong, Investors -- Cashing Out of the Market Is a Bad Idea

Selling stocks ahead of possibly the first default in the 235-year history of the United States would have been simple to do. Figuring out when to buy them again would have been the hard part.

The debt ceiling crisis brought out the market timer in many otherwise sensible investors. It's easy to understand why. For weeks, investors have been urged by some pundits on CNBC, including the oft-quoted analyst Dick Bove, to liquidate their portfolios until the debt ceiling crisis blows over.

It's terrible advice that, apparently, millions of people have followed to their detriment: According to the Investment Company Institute, long-term funds had a net outflow of $8.82 billion in June, versus an inflow of $17.68 billion in May. Not surprisingly, more conservative bond funds had an inflow of $12.93 billion in June, compared with an inflow of $19.59 billion in May. The figures will be similar for July.

The recent debt ceiling crisis illustrates just how problematic such an approach can be for investors.

Uh oh, You Sold. Now What?

Investors who hit the panic button are now in a pickle since President Obama and leaders in Congress reached an agreement to recharge Uncle Sam's borrowing capacity and slash the deficit by $2.1 trillion over 10 years. How do they decide when to buy back in?

Sure, if you are that rare individual who can time the market just right, you stand to reap huge profits buying in and out of stocks. A 2007 study by Javier Estrada of Spain's IESE Business School looked at Dow Jones Industrial Average data over the past 107 years and found that investors who that avoided the 10 worst days had portfolios that were 206% more valuable than a passive investment. However, those who failed to be invested during the best 10 days saw a 65% hit to their portfolios.

The problem is that the odds of finding the 10 good days are staggering -- they represent 0.03% of the statistical sample.

Nothing's Certain But Uncertainty

It's worth noting that Warren Buffett, perhaps history's greatest investor, is a market timing skeptic.

Sponsored Links

"Money will always flow toward opportunity, and there is an abundance of that in America," Buffett wrote in his 2010 letter to shareholders. [JB1]"Commentators today often talk of 'great uncertainty.' But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain."

If the chance of bad timing isn't enough to dissuade you from cashing out of the market, consider some of the other potential complications.

For example, liquidating 401(k) or other retirement accounts before the age of 59 and a half can be especially expensive, leaving an investor liable for both income taxes and a 10% penalty.

In short, active trading just isn't worth the hassle -- or the hit to your portfolio.

Motley Fool contributor Jonathan Berr doesn't own any stocks mentioned. He has no plans to collect can goods to prepare for fiscal Armageddon.