Topic: How To Invest

What is market timing theory?

market timing

Market timing theory attempts to interpret and detect buy and sell signals in trading patterns and history

Political tensions in Washington following the 2016 U.S. elections have reignited interest in marketing timing theory. The practice of market timing consists of coming up with and acting on a series of guesses (or estimates, or probability assessments) to use in your buying and selling decisions. The aim is the same in 2017 as it was in 1997 when the strategy gained prominence: to buy near a low and sell near a high. Market timing theory attempts to interpret and detect buy and sell signals in trading patterns and history. Some of the decisions you make with the help of market timing will bring you profits, and others will cost you money.

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Many investors start out with an exaggerated idea of the value and importance of market timing. Most eventually become disillusioned with it, after they figure out that it’s costing them money.

Market timing can pay off sporadically, of course. Although the results are largely random, successes and failures are apt to come in spurts. The worst thing that can happen to you near the start of an investing career is that you make a series of successful timing decisions. This may lead you to believe that you have a natural talent for market timing, or that you’ve stumbled on a timing process that’s a guaranteed money-maker. Either of these conclusions can spur you to back your future timing decisions with growing amounts of money.

Good timing-based decisions often produce modest profits. They tend to be smaller than the losses you get from bad timing decisions. Needless to say, one of your future decisions is bound to turn out bad. If you’ve invested enough money in it, you could wind up losing much more than your accumulated winnings from prior timing-based decisions.

The best market timing strategy I can offer is to buy steadily and carefully throughout your working years, and sell gradually in retirement. That approach is virtually certain to enhance your investing profits. For one thing, it stops you from selling all your stocks near a market bottom, which market timers do from time to time.

The worst market timing strategy you can adopt is to yield to hunches or jump to conclusions. I’m sure some skittish investors have been watching the market and trying to spot the next “correction” or temporary market setback. Of course, any market decline could be the start of a market setback.

A significant market setback of, say, 10% or more will come along eventually. Unfortunately, no one can consistently say when that will be. Trying to foresee setbacks is sure to cost you money, however. That’s because many of the setbacks you foresee won’t occur. If you act on your prediction and sell, you’ll miss out on profits. You may buy back in at higher prices, just in time to be in the market when the next setback does occur. That’s known as a “double whipsaw.”

Eventually it happens to a lot of market timers. Some react by giving up on market timing. Others just give up on investing.

Successful investors generally come to see occasional market setbacks as something you have to live with. The best way to protect yourself against them is to put money in the stock market only if you can afford to leave it there for at least two years, if not five.

How do you deal with the occasional market setback? Are constantly trying to read the tea leaves for the next market move? Or do you overanalyze and pour over data all day long? Let us know your thought process in the comments.

This post was originally published in 2012 and is updated regularly.


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