Money Matters: Market timing, does it really work?

What if you could avoid the market on down days and only be in the market when the market was going up? If it sounds too good to be true, it’s probably not worth the time to evaluate. Market timing or timers often share stories or hopes of higher returns, because they have tools to assist them in knowing when to be out of the market and when to get back in.

Unfortunately, it is not that easy.

First, if a market timer could consistently be out of the market on significant down days and get back in prior to major moves up, they would not need to be managing money for others. They could create enough wealth for themselves that they would not have to work.

BTN Research evaluated the ten year period ending May 31, 2007. Ignoring the reinvestment of dividends, the S&P 500 was up 6.1 percent per year for this period. If an investor missed the ten best days in the entire ten year period (not ten per year), the average annual return falls to 1.2 percent. If an investor was able to miss the ten worst days of the ten year period, the average annual return increases to 11.5 percent. If both the ten best and ten worst days were missed, the average annual return is 6.3 percent.

You must ask yourself, what is the possibility that an advisor can consistently miss the worst days and yet be in for the best days? The key is consistently. In my opinion, I believe it is asking the impossible and most likely the costs for such services do not add long-term value.

Taking a closer look, many of the market timers still use mutual funds to achieve their goals. Since the buyer or seller of mutual funds always receives the closing day’s price, a market timer to be truly effective should receive sell and buy signals on the proceeding day to avoid a loss or participate in a gain. So, if the market is in the middle of a 100-plus point drop when a sell signal occurs, the market timer will be selling; and unless the market recovers, the timer will lock in the loss for the day. This is because they get the closing price of the shares they sold, which is after the drop. Should the market rebound the next day, as it often does, and they buy back in during the recovery, they will then miss the bounce; as they still get the price at the end of the day, which is after the bounce.

Based upon the research by BTN, for this particular ten year period those investors who held their position during the year did almost the same as someone who through market timing missed both the best and worst ten days during the period. So is it better to buy, hold, and ignore the investment for years at a time? ‘No’ would be my answer. While I do not believe market timing can consistently perform well, there are clearly times when it is best to overweight or underweight certain positions.

A review of most of the various market indexes will show there is no consistency as to which index or area of the market will lead for a particular year. By using asset allocation, investing a portion in various different segments of the market not only adds to diversification, it increases the likelihood that a portion of your assets will be in a high-performing area of the market.

The classification for asset allocation can be type of security, stock versus bond. It can also be company size, small, mid, or large, as well as term on the bond from short, intermediate, to long. Adding global regions and industries also enhance asset allocation. While knowing which asset classes to overweight and which to underweight can still be difficult, I do not believe it is impossible to add value through asset allocation over a long period of time. Even when an overweight position does poorly, often one or more of the other assets classes used in the portfolio may mitigate the losses. Thus, the opportunity to show positive returns remains for the portfolio.

Another concern I have for market timing is that this style often creates many transactions during a year, even hundreds. For taxable accounts, this adds a great deal of time to the preparation of your annual tax turn and the proper tracking of cost basis of each transaction. With so many transactions occurring, the ability to hold something longer than one year to achieve long-term tax status is often difficult. Thus, even when market timing produces positive results, the gains can be lessened by having to pay ordinary income tax rates on short-term gains.

Aiming for realistic returns over time and having an advisor who assists you in reviewing market trends I believe will provide the results most investors are seeking. Chasing after the newest and greatest twist may just result in you ending up tired and with little to show for your efforts.

Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville TN 37801. Be sure to mark your envelope Money Matters.
Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member NASD, SIPC.

© 2007 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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