Investors and portfolio managers who emphasize the use of predictive methods to buy and sell securities are said to subscribe to the theory of market timing. Although market timing has no shortage of proponents, it is one of the most controversial theories in investment management.
Market timing stems from the principle that tools like technical analysis and economic data are suitable for making investment decisions – specifically around when we enter or exit a particular asset. A proponent of market timing will, therefore, analyze the financial markets, technical indicators and broader economic conditions to determine when to enter or exit a particular asset.
The Controversy
This form of investing is controversial because it assumes one can reliably predict the future using past data. However, seasoned investors, researchers and educators know that it is extremely difficult to predict the future direction of any market, let alone stocks, currencies and bonds.
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Market timing tends to polarize people into one of two camps. Proponents of market timing believe they can predict the future almost perfectly using complex technical indicators and “proprietary” trading strategies. On the opposite side of the spectrum, some people – especially academics – claim it is impossible to pull off. As is usually the case, the truth lies somewhere in the middle.
It’s important to note that detractors of market timing don’t necessarily discredit the use of technical analysis or economic data to inform investment decisions. Rather, they contend that the pursuit of market-beating predictions is unlikely to yield the best results. This is especially the case in the world of mutual funds, where market timing strategies have underperformed simple buy-and-hold regimes. Research on long-term portfolios also shows that aggressive market timing strategies underperform cautious portfolios that keep a fairly consistent split between stocks and bonds. These results were aptly described in 1994 by Nobel Memorial Prize winner Paul Samuelson, who argued that some of the best performers are those who adjust their portfolios only modestly over time.
Nobel Laureate William Sharpe also demonstrated the futility of market timing in a 1975 study called “Likely Gains From Market Timing.” The study sought to determine how often a market timer had to be accurate to perform equally as well as a passive index tracking a benchmark. According to Sharpe, a market timer must be correct nearly three-quarters of the time to outperform the benchmark portfolio of similar risk each year.
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At the same time, there’s some evidence to suggest that market timing strategies have their time and place. Leading German stock picker Uwe Lang apparently employed market timing to great success. He not only called buy-and-hold strategies a “profit killer,” but recommended that investors should sell their stocks no later than five days after identifying danger in the market. They should then buy them back once the broader market recovers.
Jeff Merriman-Cohen, a once-ardent supporter of market timing, told The Wall Street Journal in 2012 that trying to time your entry into the market will only diminish long-term performance. The investment advisor said, “the more complicated [the systems] are, the less likely they are to be effective.”
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Market Timing Leads to Higher Costs
Market timers not only underperform the long-term average of a passive index fund, but they are also more likely to pay for their mistakes in other ways. Market timing has a high opportunity cost, as the amount of time and effort needed to employ the strategy effectively far outweigh the benefit. Case in point: remaining fully invested in the S&P 500 Index between 1995 and 2014 would have earned an investor an average 9.85% annually – and that’s with the dot-com bubble and 2008 recession factored into the results. However, if the investor had been uninvested for just ten of the best days over that period, their return would have been 6.1%.
Entering and exiting the market at higher intervals also means higher transaction costs. Moving funds out of your portfolio or executing multiple sell orders results in much higher costs over the long term. This is especially the case when investing in funds with higher expense ratios.
Even if you succeed as a market timer, the tax implications of your gains would be significant. After all, buying low and selling high in greater frequency means higher capital gains taxes possibly every year.
The Bottom Line
While many in the investment world still subscribe to the theory of market timing, the historical trend does not work in their favor. Most of the time, you’re better off holding a passive index fund over the long haul. As the research demonstrates, being invested during the best of days can be a boon for your portfolio.
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