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Portfolio Killers: 7 Market-Timing Myths

Reprinted courtesy of MarketWatch.com.

To read the original article click here

Market timing is much too big a topic to cover in 1,000 words or less. However, so many investors are mixed up about it that I’m going to wade in with both feet to try to dispel some of the misinformation that masquerades as fact.

What is market timing? At its core, it’s the desire to find a good way to be invested in stocks when they’re going up and to be on the sidelines when they’re going down. (Timing can be applied to bonds too, but we’ll stick to stocks for this discussion.) What could be more logical than that?

That desire is the first half of market timing. The second half is the belief that “a good way” to accomplish that desire actually exists. But there’s no general agreement that there’s any such system. Otherwise, most investors would use it.

In fact, the most widely used timing system known is what I call ICSIA. That stands for “I Can’t Stand It Anymore.” This “system” trades permanent financial damage for temporary emotional relief.

ICSIA is just as simple as it is awful. When the market is going up, investors who aren’t fully invested see “everybody else” making money when they are not. Eventually their frustration is too great, and they buy — but only after prices have risen significantly. It works in reverse, too. When the market is falling, investors wait to sell until their losses become too much to bear. By that time, stock prices have fallen substantially.

Myth: Wall Street, the financial media and most investors don’t believe in market timing.

Reality: Most investors, whether they will admit it or not, believe in timing. Individuals? ICSIA is widely practiced. Wall Street? There are always lots of experts ready to tell investors why they should be in long-term bonds or short-term bonds or why they should be moving into or out of cash. Financial media? The media are always eager to quote those Wall Street experts who claim to know “what investors should be doing now.”

Of course investors, experts and the media would quickly deny they are engaging in or supporting market timing.

Myth: Market timing requires predicting the future.

Reality: Predictions aren’t reliable guides to future market performance. Much more effective are mechanical systems based on established trends. In a nutshell, the difference is this: Predictions are opinions, while established trends are facts. (See the following myth.)

Myth: Market timing, if done right, can make you a lot of money.

Reality: The “right” way to do market timing, using mechanical trend-following systems, isn’t likely to boost your returns. But it’s guaranteed to reduce your risk.

In simple terms, here’s how a mechanical trend-following system works. Once the market has been moving up or down enough to meet criteria built into the system, a buy or sell signal is generated. Imagine a voice inside the system calling out: “This is a real trend, and it’s likely to continue.”

There are two important things to note at this point. First, a “real trend” can be defined many ways, but to rise above the “noise” of the daily ups and downs, a real trend has to involve significant movement up or down. Second, that means the “little voice” never gives a buy signal until well after the market has started going up and never gives a sell signal until well after the market has started going down.

Myth: Market timing is more risky than buying and holding.

Reality: In fact, it’s just the opposite. Above, I said a mechanical trend-following system is guaranteed to reduce your risk. How can I make that guarantee? Simple: The system periodically will issue sell signals, taking you out of the market and into cash.

If you use a trend-following timing system, you are likely to be in cash 30% to 40% of the time. Every day your money is in cash, it is not exposed to the risk of the market. A buy-and-hold investor, by contrast, is exposed every single day to risk and volatility.

Myth: Market timing prevents you from losing money.

Reality: Again, the truth is just the opposite. No investment approach can eliminate the risk of loss. The primary goal of timing is to limit your losses. If you use a trend-following system, you are essentially guaranteed to lose money, because you won’t get out until the market has gone down enough to trigger a signal.

Likewise, on the upward side, you won’t get into the market until it has gone up enough to leave the bottom-of-the-market prices behind.

Myth: Because it protects investors against bear markets, timing produces higher returns than buying and holding.

Reality: It’s true that timing often produces higher returns when the market is falling. But historically, the market moves up about twice as much of the time as it moves down. Timing helps returns during bear markets, but during bull markets it is expected to produce lower returns — and it usually does.

Myth: Investors must decide to either be timers or practice buying and holding.

Reality: About half of my own equity investments are timed by mechanical trend-following systems; with the other half, I buy and hold. Sometimes one side of my portfolio does markedly better than the other. After navigating many bull markets and many bear markets, I have found that the long-term returns of each half of the portfolio are about the same.

I recommend this dual approach to long-term investors who understand timing enough to keep their expectations realistic. For me, it gives me comfort to know that when the market is going up, the majority of my equity investments are taking advantage of it — and when the market is going down, half of those investments have the ability to go to the sidelines to limit my losses.

If you want to learn more, one good place to start is with a 2011 book by Leslie Masonson called “All About Market Timing.

Richard Buck contributed to this article.