stock market timing

Why Timing the Market Is Difficult

However, stock market timing is difficult, if it’s even possible at all. There are compelling arguments against the idea of “buying the bull and selling the bear.”

1. The Efficient Market Theory
The efficient market hypothesis is a popular concept that states that all stocks are properly valued at all times based on all available information. A stock is neither undervalued nor overvalued, but it is exactly where it should be.

If this is true, market timing is impossible since prices will immediately reflect any changes upon new information becoming available. In other words, there is no time for you to react in advance of the market by buying or selling stock before it goes up or down.

2. Isolated Days of Huge Movement
A study called Black Swans and Market Timing: How Not to Generate Alpha examined the effect of outliers, or abnormal trading days, on a long-term portfolio. The study removed the 10 worst days of market activity between 1990 and 2006, and the portfolio value jumped 150.4% higher than a passive one that remained invested the entire time.

When they removed the 10 best days, the portfolio value dropped by more than 50%. But since these largely unpredictable “black swans” occur less than 0.1% of the time, the paper concluded that it’s better to buy and hold than try to guess when these isolated periods might occur.

3. Mutual Fund Performance
The paper titled Mutual Fund Performance cited a broad U.S. and UK study on mutual funds. One finding was that active fund managers were, on average, able to very slightly time the market. However, their net gains were almost entirely consumed in management and transaction fees and thereby had virtually no effect on overall fund performance. If trained professionals that actively manage mutual funds can only slightly time the market, it’s unlikely that casual investors will be able to do so at all. It’s also important to beware of common lies told by mutual fund managers.

4. Conflicting Indicators
Since there are a glut of fundamental and technical indicators available – many of which conflict – which do you follow? In other words, how do you react when the employment rate is dropping, but stocks rise to new highs on increased earnings? Should you buy when stocks are well below historical price-to-earnings ratios despite high volume selling? For every report and survey suggesting one direction, there is usually a contradicting indicator that suggests the opposite.

5. Looking to the Past
How do you prove the efficacy of a market timing model? You generally do so by back-testing it with historical data. But by constantly looking to the past to validate a system, you run the risk of curve-fitting data that appears to work well in hindsight, but may have little predictive power for the future.