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business Personal FinanceWall Street 101

Introduction | What is Risk? | Why Be Risky? | Where Does Risk Come From? | Who Can Tolerate Risk? | How To Reduce Risk | When To Avoid Risk | Timing The Market

Risk

Why shouldn't you try to time the market?

All this talk about market cycles raises an obvious question. Why don't we just jump into investments when the cycle is favorable, and back out when things are about to go sour? In this way, you could seemingly get all the upside performance with none of the downside loss.

Unfortunately, it's not that simple. (If it were, everybody would do it!) People who attempt this are called "market timers," and they are held in low esteem by professional investors because this technique fails far more than it works. In fact, the usual result of trying to time the market is the exact opposite of what you want -- you end up buying high and selling low.

Market timing also makes it likely that you won't be in the market when you really need to be -- on those days when the market turns hot, and people who are already invested reap the benefits. Consider these statistics from Ibbotson Associates Inc.:

  • There were 2,528 trading days from 1980 to 1994
  • If you'd been invested in an S&P 500 index for all 2,528 days, your average annual return would have been 17.5%.
  • If you'd missed the ten best trading days in those 14 years, your average annual return would have been knocked down to 12.6%.
  • And if you'd missed the 40 best days, you'd have made a measly 3.9%.

Only by staying invested in stocks through the entire 14-year period could you have been sure to get market exposure during those crucial hot days.

If you are a market timer, you believe that you can predict when every good day will be. But in reality, jumping in and out of the market increases the odds that you will be out of the market exactly when you should be in it -- when you could be earning the most on your investments.

Some Conclusions About Risk

  1. Risk has more to do with fluctuation in return than danger to your investment.
  2. The most potentially lucrative investments are also the riskiest. You have to be prepared to make a trade-off.
  3. The risks for each type of investment can come from a variety of sources - business conditions, political changes and others. These are often the same factors that contribute to good performance as well.
  4. Market risk is short-term. Your ability to invest aggressively is directly related to the amount of time you have to invest.
  5. Risk can be reduced through diversification and smart selection of investments.
  6. As you get older, you should move into less volatile investments.
  7. Market timers usually get burned.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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