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Lessons for Investors

Trying to time markets is a much more daunting task than picking stocks. All investors try to time markets and very few seem to succeed consistently. If, notwithstanding this history of failure, you decide to time markets, you should try to do the following:

  1. Assess your time horizon. Some market-timing indicators such as those based upon charting patterns and trading volume try to forecast market movements in the short term, whereas other techniques such as using a normalized PE ratio to predict stock prices are long-term strategies. You need to have a clear sense of your time horizon before you pick a market-timing strategy. In making this judgment, you will need to look not only at your willingness (or lack thereof) to wait for a payoff but also at how dependent you are on the cash flows from your portfolio to meet your living needs; if your job is insecure and your income is volatile, your time horizon will shrink.

  2. Examine the evidence. The proponents of every market-timing strategy will claim that the strategy works and present you with empirical evidence of the incredible returns you could have made from following it. When you look at the evidence, you should consider all the caveats from the last section, including the following:

    1. Is the strategy being fit back into the same data from which it was extracted? You should be suspicious of elaborate trading strategies that seem to have no economic basis or rationale: buy small-cap stocks with price momentum at 3 p.m. every Thursday and sell at 1 p.m. the next day, for instance. Odds are that thousands of strategies were tested out on a large database and this one emerged. A good test will look at returns in a different time period (called a holdout period).

    2. Is the strategy realistic? Some strategies look exceptionally good as constructed but may not be viable since the information on which they are based would not have been available at the time you would have had to trade. You may find, for instance, that you can make money (at least on paper) if you buy stocks at the end of every month, when investors put more money into mutual funds than they take out. The problem, though, is that this information will not be available to you until you are well into the next month.

    3. Have execution costs and problems been considered? Many short-term market-timing strategies require constant trading. The trading costs and tax liabilities created by this trading will be substantial, and the returns before these costs are considered have to be substantially higher than a buy-and-hold strategy for the strategy to make sense.

  3. Integrate market timing with security selection. While many investors consider market timing and security selection to be mutually exclusive, they don't have to be. You can and should integrate both into your overall strategy. You can, for instance, use a volume indicator to decide when and whether to get into equities, and then invest in stocks with low PE ratios because you believe these stocks are more likely to be undervalued.


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