Does Market Timing Work?

The investigation into mutual fund trading abuses that was announced by New York Attorney General Spitzer in September 2003 has given "market timing" a bad name. Unfortunately, the term, which has a more general context, gained publicity as meaning very short-term trading that is illegal or officially prohibited by some mutual funds. Nothing discussed on this site is the same as the illegal or prohibited activities that caused the mutual fund "scandals." I rarely use the term market timing now and instead say risk reduction or capital preservation models because those emphasize what the techniques are designed to accomplish. The rest of this page was written before Spitzer started making headlines, and I feel that rewriting it would detract from its instructive value.

Many investors are tempted by the concept of market timing as a way to make a lot of money trading stocks. It is deceptively easy to look at what would happen if one could buy stocks (the S&P 500 index, for example) at or near the bottom of a bear market and then sell them at or near the top of a bull market. What experienced investors have discovered, particularly if they have tried to do that, and most investment professionals know, is that timing the market is much easier said than done. First of all, while it is simple to look back in time and see them, it is very hard to identify market extremes in real time. There are various tools for trying to do so, and some can be useful in making those judgments in the hands of the right person, but none of them are at all close to being foolproof or close to 100% reliable.

A second reason market timing is extremely difficult is that it requires a high level of discipline. That means not letting your emotions getting in the way of following your decision making procedure. Many discover that when they get emotional, they look for sources of support and then they can't ignore all the noise around them and statements by noted pundits. They end up getting scared and confused and not doing what they should. Moreover, their decision making ability is greatly degraded and they lose confidence in themselves and their methods. All of that is a prescription for failure.

One reason for this behavior is thinking that market timing is the road to riches. Instead it is crucial to understand:

The main benefit of market timing

The primary purpose of market timing is enabling investors to stick with their investment plans. It can do this by reducing the volatility of investment returns. If the use of market timing only matches the market returns over time, which is a reasonable goal over longer periods of time, and does so by significantly reducing the losses in down markets, then investors using timing won't panic during such markets and dump their stocks because they are afraid of even greater losses. (Since there is always a trade-off, market timing may well miss meaningful parts of bull markets.) Usually those who sell their stocks in a panic sell near the bottom do not buy back in until prices are much higher than those they sold at if they buy back in at all. Studies of mutual fund investors' actions show that such is a typical behavior pattern.

So what's wrong with "buy and hold"?

This may sound strange coming from someone considered to be a market timer. Buy and hold is a reasonable investment strategy if you have a long enough investment horizon and can stick to it! The kicker is that only a small percentage of investors can actually stick to it. Typical investor behavior sees lots of buying when stock prices have been gaining for several years and the outlook looks the rosiest. There are always lots of reasons why the bull market is "certain" to continue for much longer, but it usually does not and emotional investors usually buy close to the top. After the first relatively small market drop, such investors will say they are "in it for the long run" and they believe in buy and hold. After stocks continue to fall, their emotions change from fear of missing out on making a lot of money (greed) to fear of suffering even greater losses (panic). As described in the previous paragraph, that is typically near the bottom. My judgment is that buy and hold is probably the most difficult investment strategy to carry out in the real world. Some can, but most can't.

I gave a talk at the Arlington, Va. public library on March 8, 2003 about market timing. It elaborates on the points above and presents some simple timing models. That talk is available for download elsewhere on the site: Timing Talk.

If you are going to try, at the least you should try to "buy low, sell high," which leads to: