What is Market Timing?
Market timing refers to an investing strategy through which a market participant makes buying or selling decisions by predicting the price movements of a financial asset in the future. Investors following the strategy aim to outperform the market by taking a long position (buying) at market bottoms and a short position (selling) at market tops.
The market timing strategy can be used to enter or exit markets or to choose between different assets or asset classes while making trading decisions.
- Market timing refers to an investing strategy through which a market participant makes buying or selling decisions by predicting the price movements of the financial asset in the future.
- It includes the timely buying and selling of financial assets based on expected price fluctuations.
- Traders use technical and fundamental analysis techniques to supplement the strategy.
When is Market Timing Strategy Used?
It can be very difficult to regularly and effectively execute a market timing strategy. Despite the fact, it appeals to investors primarily because of its potential to amass a fortune overnight as compared to the long time horizon required by most other approaches of value investing or formula acquisition.
Market timing’s provided success for professional day traders, portfolio managers and other financial professionals who can devote considerable time to analyze economic forecasts and effectively predict market shifts with such consistency. For the average investor, however, following the market daily is rather inconvenient, and it is more profitable for them to focus on investing in the long term.
How does Market Timing Strategy Work?
Market timing includes the timely buying and selling of financial assets based on expected price fluctuations. The strategy can be applied to both long-term and short-term time horizons, as per the risk and return preferences of the investor.
Usually, the trader would buy stocks when the markets are bullish and sell them off at the onset of a bear market. It involves recognizing when there would be a change in the trajectory of the price movements.
To do it, the investor must speculate how the price shall increase or decrease in the future, rather than examining the value of the financial product. An active allocation strategy, the market timing strategy aims at reaping the maximum benefits out of price inequities prevailing in the markets.
Analysis for Market Timing
Under the market timing strategy, any buying or selling decisions are based on either of the following two analysis techniques:
1. Fundamental analysis
While performing fundamental analysis, an analyst takes into account certain assumptions regarding variables that affect buying and selling decisions. Market timing is the mathematical function of such variables. It is important to find out the most accurate timing to make the decision. Fundamental analysis is used for a mid-term to a long-term time horizon.
2. Technical analysis
In technical analysis, market timing becomes a function of the historical performance of the stock and the history of investor behavior. Technical analysis is generally used for a short-term to mid-term investment horizon.
Advantages of Using Market Timing Strategy
The benefits of market timing strategy are as follows:
- Market timing is used to maximize profits and offset the associated risks with high gains. It is the classic risk-return tradeoff that exists with respect to investment – the higher the risk, the higher the return.
- It enables traders to curtail the effects of market volatility.
- It enables traders to reap the benefits of short-term price movements.
Disadvantages of Using Market Timing Strategy
Empirical research and real-life incidents show that the costs associated with the market timing strategy greatly surpass the potential benefits given that:
- It requires a trader to consistently follow up on market movements and trends.
- It entails higher transaction costs and commissions and includes a substantial opportunity cost. Market timers exit the market during periods of high volatility. Since most market upswings occur under volatile conditions, active investors miss out on the opportunities and ultimately earn less returns than buy-and-hold investors.
- An investor who succeeds in buying low and selling high must incur tax consequences on their gain. In case the security was held for less than a year, which is mostly true for market timers, the profit is taxed at the short-term capital gains rate, which is higher than the long-term capital gains rate.
- Precisely timing market entries and exits may be difficult.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: