When Timing the Market Can Actually Work
Common wisdom today tells us that timing the market doesn’t work. As hard as investors may try, earning massive profits by timing buy and sell orders around future market price movements is an elusive concept.
However, some investors can still profit from timing the market in a smaller, more reactionary way. If you are interested in tempting your fate with market timing, follow along to find out how it works and what might pay off.
What It Means to Time the Market
Timing the market is an investment strategy where investors buy and sell stocks based on expected price fluctuations. If investors can correctly guess when the market will go up and down, they can make corresponding investments to turn that market move into profit.
For example, if an investor expects the market to move up on economic news next week, that investor might want to buy a broad market index fund, an industry-focused ETF, or single stocks that he or she expects to go up, leading to a profit. Similarly, an investor can buy options, short positions, or take advantage of other investor tools to capture profits from market movements.
While this is great in theory, in practice it is seemingly impossible to make work on a consistent basis. Some investors hit it right every once in a while, but earning a profit from timing the market repeatedly is a pipedream for most.
The Market Has a Habit of Overreacting
Recent research from Dalbar Inc. found that the average investor earned a 5.19 percent return while the S&P 500 provided a 9.85 percent return over the same period. Investors underperform compared to the market thanks to emotional investing behavior, like buying when a stock price is high and overreacting to bad news.
“Buy high and sell low” is bad investment advice, but that is exactly what many irrational investors do when they enter trades based on the news and emotions. Knowing that others will make poor investment decisions, you can capture small profits when the markets overreact to market news.
For example, in 2010 Berkshire Hathaway B shares split 50 to 1 to facilitate the acquisition of Burlington Northern Santa Fe Railway. While the intrinsic value of the stock does not change from a split, it was clear that investors did not understand the concept and would rush to buy Berkshire shares at a “cheap” price after the split.
Knowing the likelihood of a price jump the day of the split, I bought shares myself and helped guide an investment fund to make a large purchase the evening before. When the markets opened, Berkshire shares flew up nearly 5 percent in the first 30 minutes of trading. It opened the door for me to sell within 24 hours for a modest profit, and the fund held its shares even longer for a bigger gain.
Taking Advantage of Small Market Dips
Predicting the next major market dip may be more difficult than winning at Blackjack in Las Vegas, but that doesn’t mean you can’t find a profit when the market dips.
In 2016, the United Kingdom voted to leave the European Union, a move dubbed Brexit. The following morning on June 24, the Dow fell 500 points while the S&P 500 fell 58 points in the first few minutes of trading. However, by the end of July, the markets had recovered and then some. It would have been a perfect moment to swoop in, buy a broad market fund, and sell for a quick profit.
Major political events, economic announcements, and mergers and acquisitions activity can all lead to market overreactions. They often behave just like Brexit, offering astute investors an opening for a profitable series of trades.
Cautionary Example of Timing the Market
Early in the summer of 2017, Amazon announced a bid to purchase Whole Foods for over $13 billion, which sent stocks ranging from Costco to Kroger on a downward spiral. Investors worried that Amazon would deal a death blow to grocery and other retailers pushed those stocks deep into the red, but they didn’t stay low for long. The retail stocks did recover somewhat, which offered investors a great opportunity on the surface.
Costco stock fell nearly 13 percent the week of the announcement, which was the stock’s worst performance since the Great Recession in 2008. That stock has yet to recover as of late July. This bet on an overreaction would have been a bad one. Kroger took a drop from around $30 per share to $22 on the Amazon news, another stock that has yet to recover from what at first appeared to be a market overreaction.
High Risks of Timing the Market
As you can see, there are big risks in attempting to time the market. In some cases, as with Brexit, there is a clear path to profits. In other situations, as happened with the Amazon deal to buy Whole Foods, investors looking to profit from an overreaction are left with a loss. Because there is a lot of risk in attempting to time the markets, never invest more than you can afford to lose.
If you time it right, you can walk away from a market timed trade with a fat profit, but in some cases, you will end up holding a loss. If you invest well and limit your exposure, earning small profits from ebbs and flows in the market is a possible route to investment success.