Some people have a good stock picking track record, like Warren Buffet and Peter Lynch, but over the long-term not even the experts can consistently beat the market.
When the market is swinging wildly, it is no indication of what will happen next. If a market begins to decline, there is no way of forecasting how far and for how long the drop will be.
Applying a rational approach to stock investing, with this efficient market hypothesis in mind, is too much for many investors. The fear of losing money overcomes rationality, and investors withdraw their investments as the market plunges.
They think they will cut their losses by taking some of their profits, and re-invest when the market bottoms out. Investment data in the S&P 500 Index shows that investors are very bad at predicting when the market has hit bottom, and too slow to re-enter the market.
This attempt at loss aversion simply does not work. Markets realize some of their biggest gains in the year or two immediately following a major correction. So all the investors that are sitting on the sidelines miss out on these rebounding returns.
The investment data clearly describes this behavior. For the S&P 500 Index: In 2008 the market declined 37%, but then gained 26% in 2009. Those not invested in 2009 missed out on these gains.
Following the dot-com crash of 2001, total stock market investment was negative in 2002, then the market returned 29% in 2003. Similarly, following the crash of 1987, total stock market investment was negative in 2008, but the market returned 17% and 32% in 2008 and 2009 respectively. Poor market timing results in a underporforming portfolio over the long-term.
Studies by Kahneman and Tversky show that investors are more worried by losses than equivalent gains. One of their experiments presented people with choice between a 100% chance of receiving $3,000 or an 80% chance of receiving $4,000. Most people choose the 100% chance of $3,000. This is rational behavior.
Reversing the scenario, people could choose between a 100% chance of losing $3,000 or an 80% chance of losing $4,000. Most people choose the 80% chance of losing $4,000. People would rather have a chance at avoiding a loss rather than a definite one, even if the sure loss is smaller. This is irrational behavior.
Overcoming this hard-wired aspect to our human behavior is not easy. Rationality is no match for an emotional argument.