As an investment enthusiast, you’ve probably heard that the best way to go is to buy low and sell high. While this is true, it can be quite challenging in practice.
To buy low and sell high, you’d need to be able to predict when the market as a whole or a particular asset (bond, stock, etc.) is at a low or high. Simply put, you’d need to time the market. This strategy is what investors refer to as market timing.
What is Market Timing, and Does it Work?
Market timing is an investment technique or strategy that involves predicting the future price of a financial asset and making buying or selling decisions based on those predictions.
The idea behind using this strategy is to beat the market by strategically timing your trades to buy a financial security low and sell it high. So, you would try to identify the best times to be in the market and when to get out. But, how well does this strategy work?
Market timing is all about predicting the future. As such, it can’t work perfectly. However, financial experts like professional day traders and portfolio managers can use this strategy effectively. But the same cannot be said for the average investor.
The reason for this is simple. People who fall into the former category are professionals who can devote a significant amount of time analyzing economic forecasts. By this consistent analysis, they can then predict market shifts efficiently.
So, the simple answer to the question, “do market timing work?” is yes; it can work with considerable time and knowledge. However, it does not work perfectly. It’s a risky strategy to use.
With market timing, you may make the right call and amass a fortune overnight. However, in the same vein, you can also make the wrong call and face grievous consequences.
How Does the Market Timing Strategy Work?
Market timing has a lot to do with being reasonable and striking in the nick of time. You’d need to act timeously, buying and selling off financial assets based on speculated price changes.
This speculation may be based on different factors, including an outlook of the market or economic conditions.
Here’s the simple process. You buy stocks when the markets are bullish (on the rise) and sell at the onset of a decline (called a bear market).
All you need to do is recognize when there would be a change in the flow of the price movements. There’s no need to examine the value of the financial asset.
Market timing is an active allocation strategy. It aims to reap the maximum benefits out of the constant price fluctuations that exist in the markets. This strategy has two types of analysis techniques.
1. Fundamental analysis:
This technique involves determining the intrinsic value of a company’s stock by studying the company itself. Using this technique, you’d disregard the market price. Instead, you’d study the industry conditions and the overall economy, as well as the company’s financial management and strength.
As such, you’d have to look at the company’s balance sheet, income statement, and cash flow statement. This is to find out the company’s assets, earnings, expenses, and liabilities.
After carrying out this analysis, you make your buy and sell decisions based on whether the stock is trading at a premium or a discount to its fair value. If the stock price trades below its intrinsic value, it’s generally considered a good investment opportunity.
2. Technical analysis:
Technical analysis involves looking only at statistical trends like the movements in a stock’s volume and price. Here, there’s no need to study the company’s financial statements to make ‘buy’ or ‘sell’ decisions.
Instead, you analyze the stock charts to identify trends and patterns that suggest where the price may be headed.
Let’s talk about a class of professionals who use market timing strategy a lot — the professional day traders.
Who are Professional Day Traders?
A professional day trader is a person who purchases and sells securities within a single trading day. And while day trading can occur in any marketplace, it is most common in the foreign exchange (forex) and stock markets.
This set of professionals execute a relatively large amount of short and long trades but within a day. This aims to capitalize on a market price action and gain from very short-term price movements.
When leveraged, day trading can maximize returns. But in the same way, it can also amplify losses.
Day traders typically use the market timing strategy. They use various leverage and short-term trading strategies to capitalize on small price movements in highly liquid stocks or currencies.
What If You Invested Only at the Top or the Bottom of the Market?
There’s no clear-cut answer to when the right moment is to invest – whether at the top or bottom. That the market hits an all-time high isn’t necessarily an indication that it has reached its peak and will begin to correct.
Similarly, a sharp fall in the market does not mean that it won’t keep falling. So, if you only invest when the market is at the bottom of the top, there’s no guarantee that the market won’t fall or rise to your loss.
In the end, what matters is that you invest smartly.
Summary
The appeal of market timing is its ability to give high returns in a short amount of time. With this strategy, you can curtail the effects of and benefit from market volatility. You can reap the benefits of short-term price movements.
However, with market timing, the higher the returns, the higher the risk, and vice versa. You also need to get updates on market movements and trends consistently. And it involves higher transaction costs, commissions, and a significant opportunity cost.
Nonetheless, you can use market timing to maximize your profits and use the high gains to offset associated risks. But, as previously stated, what matters in the end, is that you’re smart about your investment decisions.
And at the Art of Financial Planning, we’re building a community to help you with those decisions and show you how to be intelligent about your investment. Join us to learn more.
