Timing the market is a controversial idea in the world of finance, particularly in the world of financial planning. On one hand it offers the opportunity for higher returns than the market, on the other it brings about the risk of lagging the market should you fail.
At the most basic level, everyone times the market. Finance is all about how money moves through time. If you invest today, you think that there is a good chance that the market will be worth more at some time in the future, a time when you need the money for retirement, college expenses, or major purchases like a home.
Defining Market Timing
The most commonly accepted definition for market timing is buying or selling the whole market through a mutual fund, ETF, or futures position based on the idea that the market will go up or down in the very short term. In this case, the short term is a few months, or weeks, certainly not decades, or even several years.
One common way to time the market is to buy something like the S&P 500 ETF (SPY) based on when one thinks it is “cheap,” and to sell the position when one thinks the market as a whole is expensive.
Most would say that you should not try to time the market because it is very difficult to improve your performance. I think that is very good advice – timing the market is more difficult than one might think. It’s a bet that the market will be more or less optimistic about the future for all publicly-traded businesses at some time in the future.
It’s hard enough to predict things like quarterly earnings, what Washington will do about taxes, or how much the economy will grow next year. These are individual issues and concerns that affect all stocks differently. Knowing how these things will affect one stock is certainly much easier than knowing how these will affect all stocks. When you time the market, you’re essentially saying that you know better the outcome of each event that will shake the market, and how people will price those events into the market as a whole.
Focusing on What’s Knowable
In his book Margin of Safety, Seth Klarman laid out the basic framework for what makes an investment worthwhile.
He basically concludes that to be a good investment something has to:
- Be knowable – You have to have the power to know, with some certainty, at least the most important factors that drive a business.
- Allow for error – Not every piece of information is knowable. Good investors are those who “price in” their allowance for error by demanding that they not lose a substantial amount of money even if they are wrong.
Market timing seemingly moves against these two basic rules. Much of what will drive the market as a whole a week, year, or a decade from now is completely unknown. Furthermore, seeing as market timers are usually interested in small returns (5-6% in a month or two) there is not much room for error between what an investor thinks he knows about the future, and what the future may bring. Studies have shown that biases also affect would-be market timers. Investors are most bullish when stock prices are going up and most bearish when stock prices are going down. That leads to buying high and selling low, a strategy that is sure to lose.
The Solution: A Fun Money Account
Market timing gives investors the thrill of active participation in the market. Famed value investor Charlie Munger said the stock market is the world’s worst casino because it is a game with positive expectations. Even bad investors make money in the stock market because the stock market goes up over long periods of time. Bad investors just don’t realize that their accounts are going up less than the market.
If you’re looking for a thrill, and have strong financials, absolutely try your hand at managing your money any way you like. Want to buy an individual stock? Make it a tiny slice of your portfolio. Want to try timing the market? Dedicate a tiny part of your portfolio to trading. I would be sure to keep the two separate, though, just so the lines between “fun money” and “important money” are never blurred.
The worst that happens is that you lose an insignificant and learn a whole lot about how the markets work without risking your financial future. That’s a worthwhile trade-off for investors who want a little bit of thrill in their relationship with the markets.