Test Your Luck with Timing the Market

Physician's Money Digest, January31 2005, Volume 12, Issue 2

For almost as long as stockshave been publicly traded, ahotly contested debate hasraged over whether or not itmakes sense to time the market (ie,jump entirely into and out of it in aneffort to participate in gains and avoidlosses). Up until just the past few years,numerous statistical studies showedthat market timing almost never producedfavorable results. Given the combinationof higher capital gains taxrates, double-digit long-term averagereturns, and the significant transactioncosts associated with making majorshifts in portfolio investments, the costof being wrong was simply too high tomake market timing worthwhile.

Today, however, after nearly 4 yearsof substantially lower investment returns,lower capital gains rates, and, insome cases, lower transaction costs,some of Wall Street's most respected punditsare asking if the practice bears reconsideration.As with so many of life'sgreatest quandaries, the answer mayprove to be, "It depends."It dependsupon how likely it is that you are bothcorrect and early in your understandingof the actual course of events, how strongyour stomach is, and what type ofaccount you are trying to maneuver.

Ahead of the Pack

Before you can entertain the thoughtof trying to time markets, you have totake a hard look at your thought process.If you tend to make decisions from yourgut, based on intuition and emotion, tryingto time markets will probably notwork well. To have a shot at being successful,you need to be able to take acalm, rational, and extremely analyticalperspective, particularly at critical economicturning points.

You need to be able to sell when thenews is good. When new investors arepouring into the markets and analysts arerevising valuation methodologies to fitescalating prices, you need to have thediscipline to pocket the profit you havealready generated. More importantly,you need the fortitude to keep from second-guessing your decision if prices continueto rise after you have sold.

Similarly, you must be able to step upto the plate when no one else wants tobuy an out-of-favor asset class or whenmarkets seem adverse. You need to spendconsiderable time analyzing marketnuances, projecting valuations and intrinsicvalues, and assessing tax and tradingimplications and alternative investmentclasses. With hindsight, we learn thatthese critical junctures typically come justwhen things look the very best or veryworst. But figuring out how good or badit's going to get can be tough.

Behavioral scientists tell us that ourbrains are hardwired to seek patterns.We rely on familiar processes andrhythms, with our psyches striving to fitincoming data and experiences intoparameters we have seen before. Theolder we get, the more pronouncedthese tendencies become—and the moreuncomfortable we are with random,less predictable environments. Translatedinto the investing arena, this predispositioncan be a liability, sincemuch of the day-to-day movement ofthe stock and bond markets is randomand not tied to long-term reality.

While the sideways markets of 2004left many participants frustrated, it isimportant to understand that statisticsshow that 80% of the market's double-digitmoves (either up or down) are generatedin 20% of the trading days.Therefore, if you are going to be all theway in or all the way out of the market,your timing must be precise.

Taxes and Transaction Costs

Wall Street Journal

In a July 2003 article, John Bogle, the outspokenfounder of Vanguard Mutual Fundsand staunch industry critic, pointed outthat between 1984 and 2002, the averagestock mutual fund returned 9% peryear, but the average stock mutual fundinvestor earned a mere 3% per yearover the same time period due to thecosts associated with hyperactive movementfrom one fund to another.

While the federal long-term capitalgains tax rate has been cut to just 15%since the time that Bogle ran his numbers,even a 15% cut can be difficult tomake up if you move an entire taxableportfolio to the sidelines and then havejust 85% of your original investmentleft to redeploy into a better-performingasset class. Coupled with transactioncosts and our likely inability to consistentlyidentify precise turns, it is easy tounderstand how all-or-none thinkingcan result in taking two steps backwardfor every step forward.

While the stock market may or maynot trend up in the short run—making ittempting for some to go to the sidelineswith an entire portfolio—the risk of beingwrong and missing key market turningpoints remains high, even in lower-returnenvironments. And the certainties ofinflation make it even less attractive totake that risk. Its insidious effects eataway daily at the purchasing power ofyour portfolio—whether your assets areinvested and working for you long-termor are sitting on the sidelines.

is a principal of

Lowry Hill, a comprehensive, private

wealth management firm that

holds more than $6 billion of assets

for 300 client families. Lowry Hill's

investment management minimum

is $10 million. Its offices are in Minneapolis, Minn,

Naples, Fla, and Scottsdale, Ariz. Ms. Clark can be

e-mailed at cclark@lowryhill.com.

Carol M. Clark