Market timing
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Market timing is the
strategy Strategy (from Greek στρατηγία ''stratēgia'', "art of troop leader; office of general, command, generalship") is a general plan to achieve one or more long-term or overall goals under conditions of uncertainty. In the sense of the "art ...
of making buying or selling decisions of financial assets (often
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from
technical Technical may refer to: * Technical (vehicle), an improvised fighting vehicle * Technical analysis, a discipline for forecasting the future direction of prices through the study of past market data * Technical drawing, showing how something is co ...
or
fundamental Fundamental may refer to: * Foundation of reality * Fundamental frequency, as in music or phonetics, often referred to as simply a "fundamental" * Fundamentalism, the belief in, and usually the strict adherence to, the simple or "fundamental" idea ...
analysis. This is an
investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics a ...
based on the outlook for an aggregate market rather than for a particular financial asset. The
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
is an assumption that asset prices reflect all available information, meaning that it is theoretically impossible to systematically "beat the market."


Approaches

Market timing can cause poor performance. After fees, the average "trend follower" does not show skills or abilities compared to benchmarks. "Trend Tracker" reported returns are distorted by survivor bias, selection bias, and fill bias. At the
Federal Reserve Bank of St. Louis The Federal Reserve Bank of St. Louis is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., make up the United States' central bank. Missouri is the only state to have two main Federal Reserve Banks (Ka ...
, YiLi Chien, Senior Economist wrote about return-chasing behavior. The average equity mutual fund investor tends to buy mutual funds with high past returns and sell otherwise. Buying mutual funds with high returns is called a “return-chasing behavior.” Equity mutual fund flows have a positive correlation with past performance, with a return-flow correlation coefficient of 0.49. Stock market returns are almost unpredictable in the short term. Stock market returns tend to go back to the long-term average. The tendency to buy mutual funds with high returns and sell those with low returns can reduce profit.
Institutional investors An institutional investor is an entity which pools money to purchase securities, real property, and other investment assets or originate loans. Institutional investors include commercial banks, central banks, credit unions, government-linke ...
often use proprietary market-timing software developed internally that can be a
trade secret Trade secrets are a type of intellectual property that includes formulas, practices, processes, designs, instruments, patterns, or compilations of information that have inherent economic value because they are not generally known or readily asc ...
. Some
algorithms In mathematics and computer science, an algorithm () is a finite sequence of rigorous instructions, typically used to solve a class of specific problems or to perform a computation. Algorithms are used as specifications for performing c ...
attempt to predict the future superiority of stocks versus bonds (or vice versa), have been published in
peer-reviewed Peer review is the evaluation of work by one or more people with similar competencies as the producers of the work (peers). It functions as a form of self-regulation by qualified members of a profession within the relevant field. Peer review ...
journals. Market timing often looks at
moving average In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
s such as 50- and 200-day moving averages (which are particularly popular). Some people believe that if the market has gone above the 50- or 200-day average that should be considered bullish, or below conversely bearish. Technical analysts consider it significant when one moving average crosses over another. The market timers then predict that the trend will, more likely than not, continue in the future. Others say, "nobody knows" and that world economies and stock markets are of such complexity that market-timing strategies are unlikely to be more profitable than buy-and-hold strategies. Moving average strategies are simple to understand, and often claim to give good returns, but the results may be confused by hindsight and data mining. A major stumbling block for many market timers is a phenomenon called "
curve fitting Curve fitting is the process of constructing a curve, or mathematical function, that has the best fit to a series of data points, possibly subject to constraints. Curve fitting can involve either interpolation, where an exact fit to the data is ...
", which states that a given set of trading rules tends to be over-optimized to fit the particular dataset for which it has been back-tested. Unfortunately, if the trading rules are over-optimized they often fail to work on future data. Market timers attempt to avoid these problems by looking for clusters of parameter values that work wellPruitt, George, & Hill, John R. ''Building Winning Trading Systems with TradeStation(TM)'', Hoboken, N.J: John Wiley & Sons, Inc. , p. 106-108. or by using out-of-sample data, which ostensibly allows the market timer to see how the system works on unforeseen data. Critics, however, argue that once the strategy has been revised to reflect such data it is no longer "out-of-sample".


Mutual funds

Mutual fund A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...
flows are published by organizations like
Investment Company Institute The Investment Company Institute (ICI) is a global association of regulated funds, including mutual funds, exchange-traded funds, closed-end funds and unit investment trusts in the United States, and similar funds offered to investors in jurisd ...
,
Lipper Thomson Reuters Lipper (part of Thomson Reuters) is an American financial services firm. Founded in 1973 as Lipper Analytical Services, it was acquired by Reuters in 1998. Corporate history Lipper Analytical Services was founded in 1973 by secur ...
, Morningstar, and TrimTabs. They show that flows generally track the overall level of the market: investors buy stocks when prices are high, and sell stocks when prices are low. For example, in the beginning of the 2000s, the largest ''in''flows to stock mutual funds were in early 2000 while the largest outflows were in mid-2002. These mutual fund flows were near the start of a significant ''bear'' (downtrending) market and ''bull'' (uptrending) market respectively. A similar pattern is repeated near the end of the decade. This mutual fund flow data seems to indicate that most investors (despite what they may say) actually follow a buy-high, sell-low strategy. Studies confirm that the general tendency of investors is to buy ''after'' a stock or mutual fund price has increased. This surge in the number of buyers may then drive the price even higher. However, eventually, the supply of buyers becomes exhausted, and the
demand In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item ...
for the stock declines and the stock or fund price also declines. After inflows, there may be a short-term boost in return, but the significant result is that the return over a longer time is disappointing. Researchers suggest that, after periods of higher returns, individual investors will sell their value stocks and buy growth stocks. Frazzini and Lamont find that, in general, growth stocks have a lower return, but growth stocks with high inflows have a much worse return. Studies find that the average investor's return in stocks is much less than the amount that would have been obtained by simply holding an index fund consisting of all stocks contained in the
S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
index. For the 20-year period to the end of 2008, the inflation-adjusted market return was about 5.3% on average per year. The average investor managed to turn $1 million into $800,000, against $2.7 million for the index (after fund costs). Studies by the financial services market research company Dalbar say that the retention rate for bond and stock funds is three years. This means that in a 20-year period the investor changed funds seven times. Balanced funds are a bit better at four years, or five times. Some trading is necessary since not only is the investor return less than the best asset class, it is typically worse than the worst asset class, which would be better. Balanced funds may be better by reason of investor psychology.
Financial advisor A financial adviser or financial advisor is a professional who provides financial services to clients based on their financial situation. In many countries, financial advisors must complete specific training and be registered with a regulatory ...
s often agree that investors have poor timing, becoming ''less''
risk averse In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more c ...
when markets are ''high'' and ''more'' risk averse when markets are ''low'', a strategy that will actually result in less wealth in the long-term compared to someone who consistently invests over a long period regardless of market trends. This is consistent with
recency bias Recency bias is a cognitive bias that favors recent events over historic ones; a memory bias. Recency bias gives "greater importance to the most recent event", such as the final lawyer's closing argument a jury hears before being dismissed to ...
and seems contrary to the
acrophobia Acrophobia is an extreme or irrational fear or phobia of heights, especially when one is not particularly high up. It belongs to a category of specific phobias, called space and motion discomfort, that share both similar causes and options for ...
explanation. Similarly,
Peter Lynch Peter Lynch (born January 19, 1944) is an American investor, mutual fund manager, and philanthropist. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more th ...
has stated that "Far more money has been lost by investors preparing for
corrections In criminal justice, particularly in North America, correction, corrections, and correctional, are umbrella terms describing a variety of functions typically carried out by government agencies, and involving the punishment, treatment, and s ...
or trying to anticipate corrections than has been lost in the corrections themselves." Proponents of the
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
(EMH) claim that prices reflect all available information. EMH assumes that investors are highly intelligent and perfectly rational. However, others dispute this assumption. "Of course, we know stocks don't work that way". In particular, proponents of
behavioral finance Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...
claim that investors are irrational but their biases ''are'' consistent and predictable.


Viability of market timing

Whether market timing is ever a viable investment strategy is controversial. Some may consider market timing to be a form of
gambling Gambling (also known as betting or gaming) is the wagering of something of value ("the stakes") on a random event with the intent of winning something else of value, where instances of strategy are discounted. Gambling thus requires three el ...
based on pure
chance Chance may refer to: Mathematics and Science * In mathematics, likelihood of something (by way of the Likelihood function and/or Probability density function). * ''Chance'' (statistics magazine) Places * Chance, Kentucky, US * Chance, Mary ...
, because they do not believe in undervalued or overvalued markets. The
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
claims that financial prices always exhibit
random walk In mathematics, a random walk is a random process that describes a path that consists of a succession of random steps on some mathematical space. An elementary example of a random walk is the random walk on the integer number line \mathbb Z ...
behavior and thus cannot be predicted with consistency. Some consider market timing to be sensible in certain situations, such as an apparent
bubble Bubble, Bubbles or The Bubble may refer to: Common uses * Bubble (physics), a globule of one substance in another, usually gas in a liquid ** Soap bubble * Economic bubble, a situation where asset prices are much higher than underlying funda ...
. However, because the economy is a
complex system A complex system is a system composed of many components which may interact with each other. Examples of complex systems are Earth's global climate, organisms, the human brain, infrastructure such as power grid, transportation or communication ...
that contains many factors, even at times of significant market optimism or pessimism, it remains difficult, if not impossible, to predetermine the local maximum or minimum of future prices with any precision; a so-called bubble can last for many years before prices collapse. Likewise, a
crash Crash or CRASH may refer to: Common meanings * Collision, an impact between two or more objects * Crash (computing), a condition where a program ceases to respond * Cardiac arrest, a medical condition in which the heart stops beating * Couch su ...
can persist for extended periods; stocks that appear to be "cheap" at a glance, can often become much ''cheaper'' afterwards, before then either rebounding at some time in the future or heading toward
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...
. Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka,
mutual fund A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...
s. Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a buy-and-hold strategy with periodic "re-balancing". Others contend that predicting the next event that will affect the economy and stock prices is notoriously difficult. For examples, consider the many unforeseeable, unpredictable, uncertain events between 1985 and 2013 that are shown in Figures 1 to 6 ages 37 to 42of Measuring Economic Policy Uncertainty. Few people in the world correctly predicted the timing and causes of the
Great Recession The Great Recession was a period of marked general decline, i.e. a recession, observed in national economies globally that occurred from late 2007 into 2009. The scale and timing of the recession varied from country to country (see map). At ...
during 2007–2009. A 2004 study suggested that the best predictor of a fund's consistent outperformance of the market was low expenses and low turnover, not pursuit of a value or contrarian strategy. Several independent organizations (e.g., ''Timer Digest'' and ''Hulbert Financial Digest'') have tracked some market timers' performance for over thirty years. These organizations have found that purported market timers in many cases do no better than chance, or even worse.


See also

* * * * * * * * * In econometrics, a dynamic factor (also known as a diffusion index) were originally designed to help identify business cycle turning points.


References


External links


Market-Timing Strategies that Worked

Quandl Data on Estimated Long-Term Mutual Fund Flows
{{DEFAULTSORT:Market Timing Investment