Perfect Timing in the Market to Enter or Exit
In psychology, there’s a phenomenon known as hindsight bias or creeping determinism – or, more colloquially, the “I knew it all along” phenomenon. It’s exactly what it sounds like: People tend to look at past events and say to themselves, “All the signs were there! I should have seen that coming.”
Hindsight bias is a fallacy, and an expensive one in the case of trying to time the market. When we look at the past and believe the events should have been predictable, the next logical step is to try to predict future events. But there are always technical or market indicators to buy as well as to sell, making future predictions far harder than hindsight bias would lead you to believe.
Common wisdom today tells us that timing the market doesn’t work. As hard as investors may try, earning massive profits by timing buy and sell orders around future market price movements is an elusive concept.
However, some investors can still profit from timing the market in a smaller, more reactionary way.
There are few subjects in the field of investment that are more controversial than that of market timing. Some people claim it is impossible and others claim they can do it for you perfectly - for a small fee. The truth, however, may lie somewhere between the two extremes.
Timing the market is an investment strategy where investors buy and sell stocks based on expected price fluctuations. If investors can correctly guess when the market will go up and down, they can make corresponding investments to turn that market move into profit.
For example, if an investor expects the market to move up on economic news next week, that investor might want to buy a broad market index fund, an industry-focused ETF, or single stocks that he or she expects to go up, leading to a profit. Similarly, an investor can buy options, short positions, or take advantage of other investor tools to capture profits from market movements.
While this is great in theory, in practice it is seemingly impossible to make work on a consistent basis. Some investors hit it right every once in a while, but earning a profit from timing the market repeatedly is a pipedream for most.
Markets move in cycles and there are undoubtedly indicators of various kinds that at least potentially reflect the particular market phase at a given time. However, this does not necessarily mean that one can determine when to get in and out both accurately and consistently.
When you try to time the market, you have two critical decisions to make. First, you need to know when to buy, at or near the low point in the market. Second, you also have to accurately assess the high point in the market and sell before disaster strikes and the market tumbles.
In other words, you have to miraculously know the market’s bottom and top to cash in on your strategy of timing the market. You have to be right about both, which is just not very likely to happen.
Recent research from Dalbar Inc. found that the average investor earned a 5.19 percent return while the S&P 500 provided a 9.85 percent return over the same period. Investors underperform compared to the market thanks to emotional investing behaviour, like buying when a stock price is high and overreacting to bad news.
“Buy high and sell low” is bad investment advice, but that is exactly what many irrational investors do when they enter trades based on the news and emotions. Knowing that others will make poor investment decisions, you can capture small profits when the markets overreact to market news.
For example, in 2010 Berkshire Hathaway B shares split 50 to 1 to facilitate the acquisition of Burlington Northern Santa Fe Railway. While the intrinsic value of the stock does not change from a split, it was clear that investors did not understand the concept and would rush to buy Berkshire shares at a “cheap” price after the split.
Knowing the likelihood of a price jump the day of the split, I bought shares myself and helped guide an investment fund to make a large purchase the evening before. When the markets opened, Berkshire shares flew up nearly 5 percent in the first 30 minutes of trading. It opened the door for me to sell within 24 hours for a modest profit, and the fund held its shares even longer for a bigger gain.
Predicting the next major market dip may be more difficult than winning at Blackjack in Las Vegas, but that doesn’t mean you can’t find a profit when the market dips.
In 2016, the United Kingdom voted to leave the European Union, a move dubbed Brexit. The following morning on June 24, the Dow fell 500 points while the S&P 500 fell 58 points in the first few minutes of trading. However, by the end of July, the markets had recovered and then some. It would have been a perfect moment to swoop in, buy a broad market fund, and sell for a quick profit.
Major political events, economic announcements, and mergers and acquisitions activity can all lead to market overreactions. They often behave just like Brexit, offering astute investors an opening for a profitable series of trades.
Critics of market timing contend that it is nearly impossible to time the market successfully compared to staying fully invested over the same period. This basic rejection of timing has also been confirmed by various studies reported in the Financial Analyst Journal, Journal of Financial Research and other respectable sources.
In 1994, Nobel Memorial Prize winner Paul Samuelson commented in the Journal of Portfolio Management that there are confident investors who move from having almost everything in stocks to the reverse, according to their views of the market. He argued, however, that they do not do better over time than the "cautious chaps" who keep roughly 60% of their money in stocks and the remaining amount in bonds. These investors raise and lower their equity proportions only marginally - there are no big moves in and out.
So what is the solution? A portfolio comprising a manageable number of individual equities purchased and sold for the right financial and economic reasons may be the best way to invest (a total return approach). Such a portfolio is relatively independent of the overall market and no attempt is made to beat a particular index. Even more importantly, this approach does not entail market timing.
Investment magazines and internet websites also boast endless claims about market timing benefits. So can investors get this winning edge that will enable them to consistently beat the market? What about all those people out there who offer a remarkable range of methods for market timing? Each claims to have found the solution to the timing problem and provides some sort of evidence of success. They all boast of spectacular returns, often in multiples above the usual market indexes and report how they predicted various booms and crashes or the meteoric rise and fall of this or that stock.
Despite their claims, the standard wisdom is that such models do not and cannot succeed consistently over time. Certainly, both the claims and the evidence should be interpreted with caution. Some of these models may offer some benefit, but investors need to shop around, get second and even third opinions, and draw their own conclusions. Most importantly, investors must avoid putting all of their money into one approach.
After all, although it is difficult to get the timing right, particularly with each and every swing in the cycle, anybody who looked at the market in 1999 and decided to get out and stay out until 2003, would have done incredibly well.
For the skeptics, one safe solution to this totally polarized dilemma is simply to abandon timing altogether and put your money in a tracker, which literally goes up and down with the market. Similarly, most investment funds do more less the same thing. If you simply leave your money in such funds for long enough, you should do fairly well, given that equity markets generally rise over the long run.
Even if you decide not to try your luck at market timing, you should avoid a totally passive approach to investment. Managing your money actively is not the same as market timing. It is essential to ensure at all times that a portfolio has an appropriate level of risk for your circumstances and preferences. The balance of investments must also be kept up to date, meaning that as asset classes evolve over time, adjustments must be made.
For example, over a boom period for equities, you would need to sell slowly over time to prevent the level of risk of a portfolio from rising. Otherwise, you get what is known as portfolio drift - and more risk than you bargained for. Likewise, if you discover that the investment you were sold in the first place was never right for you, or your circumstances change, you may need to sell out, even if it means taking a loss.
Some professional fund managers also have systems for adjusting portfolios according to market conditions. For example, Julius Baer Private Banking in Zurich offers larger clients a "Flex Allocator" system. This is a mechanism that automatically switches the portfolio between equities and fixed-income investments. The allocator provides a degree of protection from bear markets, while optimizing profits in boom periods. The system is also adjusted according to personal risk profiles.
As you can see, there are big risks in attempting to time the market. In some cases, as with Brexit, there is a clear path to profits. In other situations, as happened with the Amazon deal to buy Whole Foods, investors looking to profit from an overreaction are left with a loss. Because there is a lot of risk in attempting to time the markets, never invest more than you can afford to lose.
If you time it right, you can walk away from a market timed trade with a fat profit, but in some cases, you will end up holding a loss. If you invest well and limit your exposure, earning small profits from ebbs and flows in the market is a possible route to investment success.
Market timing tends to have a bad reputation and some evidence suggests that it does not beat a buy-and-hold strategy over time. However, the investment process should always be an active one and investors should not misinterpret the negative research and opinions on market timing as implying that you can just put your money into an acceptable mix of assets and never give it another thought.
Furthermore, intuition, common sense, and a bit of luck may make timing work for you - at least on some occasions. Just be aware of the dangers, the statistics, and the experiences of all those who have tried and failed.
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