Market Timing Fails As A Money Maker

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.

The Basic Dilemma
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. (For related reading, see Understanding Cycles - The Key To Market Timing.)

The Critics
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. (For related reading, check out A Guide To Portfolio Construction.)

The Supporters
Conversely, the leading German stock picker and market timer, Uwe Lang, claims that when there is danger in the markets, investors should sell out of their equities within two to five days and buy them back when the market starts to rise. Furthermore, Lang calls the buy-and-hold strategy a profit killer. (For related reading, check out Ten Tips For The Successful Long-Term Investor.)

Getting the Edge
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.

Striking a Balance
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. (To learn more, read Index Investing.)

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. (To learn more about how to do this, read Rebalance Your Portfolio To Stay On Track.)

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. (To learn more, read Surviving Bear Country.)

A Case Study of A Firm that Times the Market
Timing the market with precision is a major challenge, but there are ways to figure out whether one should be going heavier into equities or bonds at a particular point in time. Or even entirely out of one and into the other.

A good example of how this can be done is provided by the Swiss company Indexplus, which uses the relationships between the economy and the market to move in and out "just-in-time". The firm's two partners, Thomas Kamps and Roland Ranz, believe in hanging on until the last moment before the crash, even if that means selling a bit below peak. The rationale for this is that large gains occur in the final frenzy of a bull market - as evidenced in 1999.

In other words, the approach is to let profits run and to minimize losses. They stress that it pays off to risk some losses, but that investors need to get out when the losses are still small. For many investors, this is psychologically very difficult and, as a result, they hang on until there are massive losses. An unemotional, high-tech model can be the best way to make these tough decisions.

Indexplus entails relatively straightforward switches between equities and bonds. The company uses a model that integrates four key variables: market psychology, interest rates, inflation and gross national product into the stock market and macroeconomic environments. A decision is then made on this basis.

The actual investments are partial replications of the Swiss index. This allows for a cost-effective, active process. Furthermore, Kamps and Ranz stress that, particularly in the efficient Swiss market, stock picking does not achieve much. The situation in the U.S. is similar. No one knows for sure how economically efficient the market is, but it is difficult to succeed consistently at stock picking. (For more insight, read our Guide To Stock-Picking Strategies.)

A Delicate Balance of Pros and Cons
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.