Market Timing - The Benefits and the Danger

Posted on Thursday, August 15th, 2019 Chris Markoch

Summary - In theory, market timing sounds easy enough. When they watch the stock market or bond market decline, even experienced investors may find the psychological effect, not to mention the loss of wealth, hard to stomach. But what if they didn’t have to? What if they could simply move their money out of the market before it drops and then jump back in when the waters are safe? And better still, what if they could shift their asset allocation from stocks to bonds that move in an inverse relationship so that instead of just breaking even, there are actually profiting from market volatility?

This is the theory behind market timing. And practitioners of market timing swear by it. To them, market timing is possible because of the technical signals that the market creates. By simply following these patterns, investors can enter and exit trades – and even entire asset classes – and watch their portfolio soar.

But in reality, if it were that easy everybody would be doing it. The reality of market timing is that it is extremely difficult because assets frequently behave in an irrational manner. The advantages of market timing are simple enough: bigger profits, smaller losses, a way to avoid the volatility in the market, and an opportunity to benefit from short-term price movement. However, the disadvantages of market timing are that it requires nearly constant attention to the market, the profit achieved has to overcome the increased fees and commissions, there can be tax implications on short-term capital gains. And most importantly, it is hard to correctly identify entry and exit points.

Market timing is not limited to investors who choose their investment on an a la carte basis. Mutual fund investors can also be subject to market timing when they choose a fund that is actively managed. These funds seek to beat the index or sector that the fund is linked to by actively buying and selling the assets that make up the particular fund. The risk is that in addition to correctly timing the market, they have to ensure that the performance of the fund is sufficient to overcome the increased fees.

Although empirical research tends to confirm that a passively managed portfolio will beat a portfolio that attempts to time the market, the debate about whether or not market timing really works will continue as long as investors are willing to try it.

Introduction

Can investors ever really time the market? And even if they can, is the reward worth the risk? Those are the questions surrounding a practice known as market timing. In its most clinical definition, market timing involves actively seeking out technical indicators such as an asset that crosses over its 50-day moving average as a predictor of future movement. In this article, we’ll break down the strategy of market timing. In addition to reviewing the benefits and the disadvantages, we’ll attempt to answer the question of whether market timing actually works and help you understand why mutual fund investors may be involved in market timing even if they don’t realize it.

What is the definition of market timing?

Market timing is an investing and trading strategy that involves shifting the assets inside a portfolio to take advantage of pricing inequities within different asset classes. Market timing is considered to be an active asset allocation strategy. Market timing is the opposite of a buy-and-hold strategy, although some long-term investors may engage in short-term market timing strategies when a particular asset class is outperforming other assets. Market timing relies on predictive tools such as following technical indicators (moving averages, oscillators, etc.) to make an educated guess for how the market is going to move.

What are the benefits of market timing?

Advocates of market timing will point out that they are doing nothing more than buying low and selling high, which is exactly what successful investors do on a daily basis. These traders would say that market timing strategies help them take advantage of market volatility by moving in and out of sectors before a drawback. Market timing traders will frequently trade the trend and use established technical models to set entry and exit points. More experienced traders will even come up with their own custom models and formulas.  With that said, the potential benefits of market timing include:

  • The opportunity for large profits
  • The opportunity to limit losses
  • The ability to limit the effects of volatility
  • The ability to take advantage of short-term price movement

This last point is something that most traders would concede about market timing. It is a strategy that is suited for short-term trading. The kind of movement in asset classes that make market timing profitable tend to happen in very short windows.

What are the disadvantages of market timing?

Opponents of market timing will point out that trying to time entry and exit points for any asset is difficult if not impossible and frequently results in underperforming an investor who stands pat and rides out periods of volatility. Furthermore, moving in and out of trades can impact an investor’s total return due to transaction costs, commissions, and future tax liability. Keeping this in mind, the disadvantages of market timing include:

  • The need to keep close, even daily focus on markets
  • The added expense from transaction costs and commissions
  • The tax burden from short-term capital gains
  • The imperfect science of finding entry and exit points

Mutual funds are not immune from market timing

Mutual fund investors can be affected by market timing if they are invested in an actively managed fund. When you invest in an actively managed fund, you are paying the fund manager to actively work at beating the return of the market index that the fund is tied to. In order to do this, the fund manager takes an investment approach that seeks to exceed the return of the broader market.

An active portfolio manager uses their experience and market knowledge to select the underlying assets of a particular fund in a á la carte fashion. An active portfolio manager will typically have their own research methodology or they may be part of a fund group that uses a unique methodology. This methodology is used to select the assets that make up their fund. The challenge for the active portfolio manager is to get a return that exceeds the expenses of their particular fund, which are higher than those of a passively managed fund.

An investor might consider active portfolio management if they:

  • Have an above-average risk tolerance
  • Are comfortable with more buying and selling activity in their portfolio
  • Are comfortable investing in international or emerging market sectors and fixed income assets where active management is still seen as offering an advantage

Can market timing be a viable asset allocation strategy?

The goal of asset allocation is a diversified portfolio, not only among asset classes (stocks, bonds, cash, precious metals, etc.) but also within asset classes. For example, an investor may choose to have a mix of dividend stocks and growth stocks. They may also look to have a mix of large-cap, mid-cap, and small-cap stocks. Asset allocation seeks to maintain a specified asset mix. To accomplish this, an investor will engage in defensive strategies, which do not employ market timing tactics and offensive strategies which do employ market timing tactics. With offensive asset allocation strategies, an investor will intentionally deviate from their specified asset mix to chase a larger return in another asset. This approach can work, but it requires that the investor have the discipline to revert back to their specified mix once they have achieved their objective.

Can market timing be a successful investment strategy?

Whether market timing works or not is largely a matter of opinion. Many financial professionals and economic theorists firmly believe that it is impossible to time the market. Active traders, on the other hand, believe that it can. What seems clear is that market timing only works in very limited amounts of time. In the long run, it is difficult to consistently time the market.

At the core of the market timing debate is an investor’s approach to volatility. A report by the Boston research firm Dalbar documents how an investor that remained fully invested in the S&P 500 Index between 1995 and 2014 (a period that included extreme bull and bear markets), their annualized return would have been 9.85%. However, if an investor would have tried to call a market top and left the market on 10 of its best days, their return would have been down to 5.1%.

This statistic makes sense, in theory. However, there is no way of knowing if an investor may have received a larger return by putting their money in a better performing asset. Perhaps a better example comes from the research firm Morningstar who estimated that between 2004-2014 actively managed portfolios had a return that was 1.5% less than passively managed portfolios. According to Morningstar, an active investor would have to be right 70% of the time to get an edge over passive investors. This research complemented the 1975 landmark study by Nobel Laureate William Sharpe. Sharpe concluded that an investor using a market timing strategy must be correct 74% of the time to beat the benchmark portfolio of similar risk on an annual basis.

The bottom line on market timing

Mark Twain is attributed with saying “History doesn’t repeat itself, but it frequently rhymes.” Looking for predictable, repeatable patterns is the theory behind market timing. As a strategy, it is simple enough. In practice, though the market does not always behave rationally. In fact, some people would say it rarely behaves rationally. The advocates of market timing will say that by falling technical indicators they can profit from short-term price inefficiencies among asset classes. However, research done by leading economists and market analysts suggests that, over time, a passively managed portfolio (buy and hold) will outperform an actively managed portfolio that seeks to time the market.

In the end, the answer is really a matter of opinion and probably more importantly investment style. Over short periods of time, market timing has shown that it can be successful. However, it is best left to experienced traders who have the technology and the time to monitor the market to ensure they are entering and exiting trades at the proper time.

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