Market timing is the attempt to move money into or out of a market, or between asset classes, based on predictions of where prices will go next. A market timer might sell shares and hold cash before an expected fall, then buy back in before an expected recovery. The aim is to capture the gains of a bull market while avoiding the losses of a bear market.
The term has a second, regulatory meaning in the United States: frequent short-term trading in and out of mutual fund shares to profit from prices that have not caught up with market news, a practice at the centre of the 2003 mutual fund scandal. Market timing is the opposite of buy-and-hold investing and of dollar cost averaging, and it overlaps with tactical asset allocation.
Market timing in plain terms
Imagine trying to surf only the biggest waves. If you could tell exactly which ones were coming, you would paddle out just in time and rest on the beach the rest of the day. In practice the sea gives little warning, and someone who keeps going back to the beach to wait often misses the best waves altogether.
Markets behave much the same way. The idea of being in for the rises and out for the falls is appealing, but it requires being right twice, once when getting out and again when getting back in. Missing a handful of strong days can cost more than the losses the timer was trying to avoid.
Methods used by market timers
- Technical signals. Chart patterns and indicators such as moving-average crossovers (for example the golden cross) and the relative strength index.
- Valuation measures. Reducing equity exposure when the market's price-to-earnings ratio is far above its history, and adding when it is low.
- Economic indicators. Signals such as an inverted yield curve, which has often preceded a recession, or changes in interest rates.
- Sentiment. Contrarian moves against extremes of fear or greed, such as waves of FOMO buying.
- Systematic rules. Trend-following models, often run through algorithmic trading, which switch exposure according to fixed rules.
The evidence
Most academic and industry research finds that consistently successful market timing is rare. Strong rebounds tend to come close to the worst falls, often within days, so investors who sell in a panic frequently miss the recovery; a short-lived rally such as a dead cat bounce can also lure timers back in too early. Studies of fund flows repeatedly find that the average investor's return is below the return of the funds they own, because money tends to flow in after strong performance and out after losses. Trading also brings costs: commissions, bid–ask spreads and tax on each realised capital gain. Some professional strategies, such as trend following in futures markets, have documented records over long periods, but results vary widely by period and manager.
Mutual fund market timing and regulation
A US mutual fund prices its shares once a day at net asset value, usually at 4 p.m. Eastern time. For funds holding foreign shares, the closing prices used may be many hours old, so a trader who buys after good news in the US, before Asian markets reopen, can lock in an almost certain gain at the expense of long-term shareholders. In September 2003 the New York Attorney General, Eliot Spitzer, brought a case against the hedge fund Canary Capital Partners alleging late trading and market timing in several fund families, leading to settlements with many large fund firms.
In March 2005 the Securities and Exchange Commission (SEC) adopted Rule 22c-2 under the Investment Company Act of 1940. It requires a fund's board to consider whether to charge a redemption fee of up to 2% on shares sold soon after purchase, a fee that is kept by the fund, and requires most funds to have agreements with intermediaries so they can see the identity and trades of underlying investors. Funds also apply fair-value pricing to stale foreign prices and disclose their frequent-trading policies in the prospectus. Many limit how often investors can use an exchange privilege to switch between funds.
Criticism and alternatives
Critics argue that market timing turns long-term saving into speculation and that most investors would do better holding a fixed allocation suited to their time horizon and risk tolerance, rebalancing periodically. Supporters reply that avoiding even part of a deep decline, as in 2008, can matter greatly to someone close to retirement. A middle ground used by many institutional investors is to allow only modest tactical shifts around a strategic allocation.