The Advantages and Disadvantages of Market Timings
Investors in the stock market can benefit from formulating investment strategies based on the security analysis of market dynamics, corporate factors, and economic as well as political movements. This investment strategy of taking trading decisions based on analytical techniques is called market timing.Individuals typically decide to sell or buy stocks, or switch between asset classes, using fundamental and technical indicators, as explained below:
Fundamental indicators: These involve an analysis of the financial performance of a company to predict the mid or long-term movement of its stock.
Technical indicators: These involve an analysis of the past performance of the stock itself. These indicators also study investor trends to make small or mid-term predictions.
Market timing strategy helps investors handle the uncertainty associated with price fluctuations. However, market timing also involves a considerable amount of risk since the decisions are taken entirely based on predictions.
Advantages of market timing
Investors can reap several benefits from market timing. It is beneficial to those who understand the strategy and are able to apply it in their plans productively. Here are some advantages:
1. Enhanced profits
Market timing strategy has a strong potential to boost an investor’s profit. If an individual correctly assesses whether the stock or security (which is currently being traded at a lower price) has the potential of a higher trading price, they can make good profits. Alternatively, an investor can also shift their investment from one asset class to another, depending upon the predicted movement of various asset classes. People are likely to make higher profits when the market is at its best.
2. Cut-down losses
This approach allows investors to gain insight into the future, thereby allowing them to reduce their losses. This can be achieved by not investing in funds or assets which are not expected to show potential for favourable returns. Based on an investor’s analysis, one can immediately sell stocks whose prices are most likely to fall. People can also withhold those whose prices are already low and are likely to increase in the near future. Individuals can expect considerably low losses during the worst periods of stock trading.
3. Avoidance of volatility
One of the major benefits of market-timing is the reduction in investment risk. This is achieved by helping people avoid volatility associated with the securities or the stock market itself. When proceeds from a security or a market index demonstrate a higher standard deviation or variance, it implies higher volatility. When security displays higher volatility, it means that the investment risk associated with it also is higher. Market timing is instrumental in allowing an investor to dodge volatilities to some extent.
4. Short-Term investment predictions
Market timing is the most beneficial when investors act on the predictions made over a short period. The profitability of this approach is considerably high when individuals shift from one asset class to another, but only during the extremely short-term time frame.
Disadvantages of market timing
While market timing has its benefits, it can have certain drawbacks as well. These must also be kept in mind while adopting this approach. Here are some disadvantages:
1. Opportunity cost
Though market timing allows security against volatility, it also takes away an earning opportunity from investors. The market has the potential to make maximum profits when it is volatile. So, investors may have to bear the opportunity cost of avoiding the volatility of the market when they follow the market timing strategy.
2. Continuous market observation
To reap maximum benefits from the market timing strategy, it is necessary to keep a continuous check on the movement of securities, funds, and asset classes. The market has to be under constant scrutiny, with no scope of leaving it unattended. This job can be tedious, time-consuming, and draining.
3. Elevated transaction and commission costs
Each time an investor enters or exits the market on account of the market timing analysis, there are transaction costs and commission expenses that have to be borne. As per recent happenings, the performance of mutual fund investors’ indices showed a decline. This underperformance was the result of constantly moving in and out of funds or fund classes and trying to benefit from profitable funds. This also incurred high transaction and commission costs. These were specifically high for funds whose expense ratios were more than 1%.
4. Higher tax rate
Profits are earned by investors when they buy securities or funds at lower rates and sell them at a higher price. However, when stocks are bought and sold within a year, the profit earned is taxed according to either the usual income tax rate or the short-term capital gains rate. Both these figures are considerably more than the rate charged on long-term capital gains. This implies that while individuals can make extra profits from the market timing strategy, the additional gain is equalized by a higher tax rate that is levied on those gains.
5. Complexities in determining entry and exit timings
The fact that investors earn profits by buying and selling stocks at the right time may sound simple and uncomplicated. Another popular notion is that an investor’s job is limited to checking a couple of technical and fundamental analysis outcomes and taking decisions accordingly. However, the reality is not this easy. It is a complex task to determine the right entry and exit point since the market and its trends keep changing constantly. A single mistake in predictions can result in significant losses or a loss of opportunity for the investor.
The final verdict
Market Timing as an investment tactic has its advantages and disadvantages. Each investor has to weigh them depending on their expectations and needs. While some people might benefit from it, others might not find it very profitable. Short-term gains will be able to fulfil the investors’ daily needs. But one cannot ignore the drawbacks of associated costs that will have to be incurred in the future. Hence, the pros and cons of market timing are subjective and must be understood from an individual perspective.
To sum it up
One can enter and exit the stock market or switch between asset classes based on the analysis of several long-term and short-term indicators. The market-timing approach can be beneficial to those who are quick decision-makers and can be proactive. However, this strategy might not be useful alone. It should be combined with other decision-making methods for trading. Investors also need to have the expertise required to undertake an analysis of fundamental and technical factors.
However, not all investors are equipped with the knowledge to gauge the dynamics of trading techniques. Before adopting a specific investment strategy, you can appoint a professional financial advisor. They will help you devise strategies that will align with your needs, keeping in mind your expectations and risk absorbing capacity.