Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods such as technical indicators or economic data. Because it is extremely difficult to predict the future direction of the stock market, investors who try to time the market, especially mutual fund investors, tend to underperform investors who remain invested.
Some investors, especially academics, believe it is impossible to time the market. Other investors, notably active traders, believe strongly in market timing. Thus, whether market timing is possible is really a matter of opinion. What can be said with certainty is it is very difficult to successfully time the market consistently over the long run. For the average investor who does not have the time, or desire, to watch the market on a daily basis, there are good reasons to avoid market timing and focus on investing for the long run.
While market timing is not impossible to do, few investors have been able to predict market shifts with such consistency that they gain any significant advantage over the buy-and-hold crowd. In the estimation of Morningstar, actively managed portfolios that moved in and out of the market between 2004 and 2014 returned 1.5% less than passively managed portfolios. According to Morningstar, to gain any edge, active investors have to be correct 70% of the time, which is virtually impossible over that time span.
For investors, the real costs of lost time and opportunity are almost always greater than the potential benefit of shifting in and out of the market.
Opportunity Costs: Research shows that, if an investor remained fully invested in the Standard & Poor’s 500 Index from 1995 through 2014, he would have earned a 9.85% annualized return. However, if he missed only 10 of the best days in the market, his return would have been 6.1%. Some of the biggest upswings in the market occur during a volatile period when many investors flee the market.
Transaction Costs: Countless studies have shown that mutual fund investors who move in and out of funds and fund groups trying to time the market or chase surging funds underperform the indices by as much as 3% due to transaction costs, especially when investing in funds with expense ratios greater than 1%.
Taxation Costs: Buying low and selling high, if done successfully, generates tax consequences. Add to this the hidden tax consequence of investing in high turnover funds that generate substantial tax consequences affecting investor returns.
Numerous studies have illustrated the futility of market timing. One was performed by famed Nobel Laureate William Sharpe in 1975. The landmark study, "Likely Gains From Market Timing," attempted to find how often a market timer must be accurate to perform as well as a passive index tracking a benchmark. Sharpe concluded that an investor employing a market timing strategy must be correct 74% of the time to beat the benchmark portfolio of similar risk annually.