The Folly of Market Timing

The Folly of Market Timing These days, some people may have a 'sure-fire' way to time the stock market. Just check out the Internet. You can find screens advertising market timing services. A trip to your local library will yield an equal abundance of market timing theories in books, magazines, and other periodicals. And some of these theories may or may not work.

The Premise
The idea behind market timing is to buy stock when prices are low, hold onto your investment until the market peaks, and subsequently move your stock investments into cash until the market hits bottom. Then, the process begins all over again. It sounds simple enough. The problem, though, is that all timing theories are based, at least in part, on second guessing the stock market. Different timing theories consider various 'indicators' that may signal that the market is about to head up or down: margin debt, interest rates, employment data, manufacturing levels, number of advancing stocks versus number of declining stocks, and so on. However, even with the most sophisticated methods, hitting the exact highs and lows of the market is next to impossible.

What happens if your timing is off and you don't reinvest in the market at the right time? The consequences of not being fully invested when a major market upturn occurs can be disastrous to your long-term investment plans. Studies of stock market history have shown that not being invested at the 'right' times can be costly to an investor. Consider the following hypothetical example based on the return of the S&P 500.

On June 30, 1994, Susan invested $10,000 in a stock index fund based on the S&P 500 Stock Index. As noted in the chart below, by June 30, 2004, the $10,000 would have grown to $31,260, an average annual total return of 12.07%.

However, suppose Susan decided to get out of the market periodically during that five-year period, and as a result she missed the market's ten best single-day performances. If that were the case, her 10.04% return would have fallen to 4.95%. As well, if Susan missed the market's best 20 days, that 10.04% return would have dropped to 1.11%. Of course, the performance of an unmanaged index is not indicative of the performance of any particular investment. The performance of an index assumes no transaction costs, taxes, management fees or other expenses. It is not possible to invest directly in any index. Past performance cannot guarantee comparable future results.

The Penalty for Missing the Market
Trying to time the market can be an inexact - and costly - exercise. This chart illustrates a $10,000 investment in the S&P 500 Index from Dec. 31, 1994 - Dec 31, 2004.
Period of investment Average annual total return Growth of $10,000
Fully Invested 12.07% $31,260
Miss the Best 10 Days 6.89 19,476
Miss the Best 20 Days 2.98 13,414
Miss the Best 30 Days -0.39 9,621
Miss the Best 40 Days -3.19 7,233
Miss the Best 60 Days -7.90 4,390
Source: Factset Research Systems as provided by AIM Distributors, Inc.

The Best Defense
Market fluctuations can make almost any investor nervous. But getting out of stocks when the market takes a downturn isn't the answer. Don't let short-term volatility drive your long-term investment planning. Your best defense against a fluctuating market is a well-diversified portfolio and a disciplined program of periodic investments.

Spreading your investments among stocks, bonds, and cash in a strategic asset allocation that takes into account your time horizon, risk tolerance, need for investment income, and long-term goals can help your portfolio produce more consistent returns, regardless of whether the stock market is up or down. When the stock market is not performing well, your returns from bond and cash investments can help supplement your stock returns. Making regular investments in a stock or stock mutual fund when the market is down as well as when it is on the rise is a strategy known as dollar cost averaging. With dollar cost averaging, you invest a fixed amount monthly or quarterly. When the market is down, your money buys more shares. Over the long-term, the average price you pay per share generally may be lower than the average price of the stock investment during the same period. Investing regular amounts steadily over time may lower your average cost but cannot guarantee a profit or protect you from a loss in a declining market. Effectiveness requires continuous investing regardless of fluctuating prices. You should consider your ability to continue buying through periods of low prices. Wise investors don't try to second-guess the financial markets. They take a structured, disciplined approach to investing that recognizes that market declines inevitably will occur.

Eric C. Weiss is a registered representative of Lincoln Financial Advisors, a broker/dealer, and offers investment advisory service through Sagemark Consulting, a division of
Lincoln Financial Advisors Corp., a registered investment advisor. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.
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