What Is Market Timing?
Does “buy low, sell high” hold up in the modern era? Can any of us successfully time the stock market? Inside, learn about the pros and cons of market timing.
October 6, 2021
Investing is a great way to build long-term wealth. But can you accelerate your financial success by timing your trades in a particular way?
With wild fluctuations in the stock market on a daily basis, it can be tempting to think about what-ifs: What if you had bought Tesla stock at $10 per share? What if you had sold your portfolio right before the spring 2020 market crash?
Some people do try to predict these changes in the market and time their buying and selling accordingly. That’s what market timing is all about — but is it worth pursuing?
What is market timing?
Market timing is the act of buying or selling assets at certain times, based on the predictions of the investor.
Examples of market timing include:
Selling index funds because you think the market is overvalued
Buying equities aggressively because you think they will quickly rise
Selling a stock because you think the company’s next earnings report will be poor
Buying an investment with the intent to sell it shortly afterward
Selling stocks and buying bonds because you think a market crash is coming
In essence, market timing involves making a short-term prediction and adjusting your portfolio to take advantage of that prediction.
There are pros and cons of market entry strategies like these and other market timing techniques.
Can potentially produce excellent returns if executed correctly
Can potentially avoid the worst losses during market crashes
Can potentially accelerate wealth building and help you retire early
Extremely difficult to time correctly
Produce worse results than a buy-and-hold strategy for most investors
Can be stressful
Does market timing work?
Market timing can work, but it’s exceptionally difficult. For the average investor, market timing doesn’t work as well as you might think.
Even if you manage to predict when the market is going to crash, you then have to correctly predict when it starts to rise again. As demonstrated by this chart, missing out on just a few of the best recovery days after a market crash can significantly reduce your long-term returns.
Psychology often works against us, causing us to panic sell when the market crashes and buy more when the market is near its peak.
For institutional investors, like hedge funds, day traders and investment banks, market timing strategies are commonly employed. Many hedge funds find success in this strategy, while many others fail and end up underperforming the overall stock market.
This was famously demonstrated by a bet from legendary investor Warren Buffett. In 2008, Buffett wagered one million dollars that the returns of the S&P 500 — an index of the largest 500 publicly traded companies in America — would beat a group of five hedge funds over the next ten years.
In 2018, Buffett’s wager proved correct: The S&P 500 returned 125.8% over the ten years, while the average of the five hedge funds returned just 36%.
With that said, there are examples of certain hedge funds who employ market timing doing substantially better than the overall market. However, these companies inform their decisions with their hundreds, if not thousands, of employees, as well as the latest technology and algorithms.
For everyday investors, market timing is generally not advised. So, what’s the alternative?
Timing the market vs. time in the market
There are basically two schools of thought when it comes to investing:
Active trading: which employs stock picking, market timing and other strategies
Passive investing: which employs a simple buy-and-hold strategy
Proponents of the “time in the market” approach argue that it’s difficult to predict the movements of the market, so it’s better to simply invest and forget about it. This passive strategy has some substantial benefits.
First, it’s easier. You can start investing in diversified index funds, set up auto-investing and then move on with your life.
Passive investing often works out very well for long-term investors. Over the last 100 years, the broad U.S. stock market has returned approximately 10% per year, on average. Through the power of compound investment returns, relatively small investments can grow into substantial wealth over the years.
The risk of losses is actually lower with a passive strategy. While you might think that active trading could avoid losses — by selling before a market crash, for instance — in many cases it actually increases the risk of selling at a loss.
With passive investing, you might see the value of your investments dip, but if you hold on until they recover, you may not actually lose any money.
Should you try to time the market?
Ultimately, the decision to be an active investor or a passive investor is up to you.
If you prefer a simpler, tried-and-true approach, try passive investing. If you enjoy actively trading and being involved in investing day to day, then attempting to time the market may be worthwhile.
For many of us, optimizing other aspects of our financial lives will deliver greater results than trying to squeeze out slightly more from our investments.
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