Market timing is an investing strategy that involves making assumptions about what the price of a security will be at a certain time. Market timing can be either bearish or bullish, and it can be made with short-term or long-term movement in mind. Anytime an investor acts solely on their belief about where the price of a security is going, it's a form of market timing.
Learn more about market timing and why so many advisors will tell you to fight the urge to use this strategy.
What Is Market Timing?
Market timing simply refers to any predictions an investor makes about price movement. When an investor thinks a stock price will be above or below a certain price on a certain day, that is market timing. These sentiments can stem from any number of ideas or assessments, such as studying a historical price chart and attempting to learn patterns.
Market timing can apply to any security. Stocks are the most common example, but someone can also use market timing to guide their bond, gold, or real estate investments. Anything that's subject to market forces could be traded with market timing.
Market timing is generally considered a risky strategy. Correctly timing the market may come with a substantial payout, but the likelihood of repeated success with market timing is much lower than many other strategies for building wealth. As the saying goes, "Time in the market is better than timing the market."
How Does Market Timing Work?
Market timing can be employed as an investing strategy in many ways. It all depends on what exactly an investor thinks will happen.
For instance, if an investor sees a stock trading at $80 on Monday, and they feel it will drop down to $78 by the end of the week, then they may short the stock or buy a put option that expires Friday. Both of those trades are bearish—they depend on the stock price going down to make money. If the stock price falls below as the investor hoped, then they make money. If the stock price rises, then the investor's market timing failed, and they lose money.
The opposite works, as well. If an investor thinks a stock price will rise, they may go long on a stock or buy a call option that expires on the day they think the stock will rise by. They may even use margin debt to act on their sentiment, adding extra risk to an already risky strategy in hopes of sudden riches.
If an investor sells their stock because they're afraid about an impending stock market crash, that's another example of market timing. This particular example shows the high levels of risk and reward that come with market timing. Even if it's clear that an asset bubble is forming, it's incredibly rare that someone accurately predicts a crash to the day. However, if someone manages to do so, they'll be able to buy back into the same positions at a much lower price.
The opposite of market timing is a formulaic or systematic approach. Rather than guessing about where a stock price is going to be on a set date, systematic investors try to ignore prices altogether. No matter what the price, they buy the same amount on a regular schedule. Examples of this include dollar cost averaging, dividend reinvestment plans, and 401(k) payroll deductions.
Valuation vs. Market Timing
|Valuation vs. Market Timing|
|Attempts to estimate the value of the company||Attempts to estimate where a stock price is going|
|Concerned about stock price only as it compares to value||Concerned only with stock price|
|Calculates value by using financial documents and ratios||Studies chart patterns and investor sentiment|
While the differences between formulaic investing and market timing are more clear, the differences between valuation and market timing are a bit more nuanced. They both base investments on estimations, rather than relying on a systematic approach. However, there are major differences between the types of estimates made.
Valuation involves complex financial analysis that digs into the actual business behind the stock price. Various financial ratios will likely be used to give greater context about how much money the company is making, how it's making it, and how likely the company is to grow its earnings. To obtain the information needed to calculate these equations, the investor must pour over balance sheets, income statements, and any other financial documents they can get their hands on.
Only after assessing the value of a company will a value investor look at the stock price. That's because the stock price in and of itself matters little to this type of investor. Instead, what matters is how the stock price compares to the overall value of the company. If the stock price is low, relative to the value, then the investor will buy it. If the stock price is much higher than the "true value" of the company, then the investor will look for opportunities elsewhere.
Market timing, on the other hand, is solely concerned with a stock's price. The underlying value of the company doesn't matter, the only thing that matters is correctly guessing where the stock price will be on a set day. An investor using market timing my study stock charts to attempt to learn the patterns of the stock price, but there's no fundamental assessment of the company's actual finances.
- Market timing is a type of investing that attempts to make specific guesses about where a stock price will be on a given day in the future.
- Market timing can take many forms—bullish, bearish, short-term, long-term, etc.
- Market timing is the opposite of formulaic investing strategies such as dollar cost averaging. It's also much different than value investing.