Here’s the Secret to Market Timing

The first two things that new investors are taught are “buy low, sell high” and “market timing is futile.”

“Buy low and sell high” is common sense, but market timing can be tremendously valuable if done right. The problem is that it is often done incorrectly and can destroy returns rather than enhance them.

The disdain for market timing is based on the belief that it is impossible to predict what the market might do in the future. Many investors like to believe that they have some special insight that will allow them to navigate the market in a timely way, but the reality is that no one has ever called the twist and turns of the market over a long period of time with any great level of accuracy.

The logic is that if you just hold on to “good” stocks, then you don’t need to bother with market timing. Great stocks always come back, so just hold on like Warren Buffett would, and it will pay off.

Holding on to good stocks is pretty easy when volatility is at “normal” levels, but even the best stocks can suffer gut-wrenching drops. Apple (AAPL) , for example, has been hit with two drawdowns of over 80%. One from 1991 to 1997 and one from 2000. It took a while to recover those losses, but if you had avoided those pullbacks to some degree, you would have increased your returns substantially.

The danger is far greater if your stock selection is poor. Holding on to the wrong stocks instead of using some sort of timing approach will destroy your portfolio.

The one great certainty of the market is cycles. Bear markets occur every few years, and those pullbacks can cripple returns for years. If you can find ways to avoid them to some extent, then you are ahead of the game. Avoiding a bear market sounds pretty simple in retrospect, but it is extremely difficult to do in practice, which is why there is so much advice about not trying to time the market.

The key to effective market timing is to have a very clear plan for rebuying your favorite long-term plays as they recover. The failure to buy back stocks that were sold is the biggest problem with market timing. Selling into poor action is easy, but the problem is that inertia tends to set in and that money is never put back to work, or it is redeployed in attempts to catch a bottom.

Don’t overcomplicate it. It isn’t necessary to use fancy indicators, volatility measures, stochastics, or a host of other tools. Indicators often produce a false sense of precision. The key is to focus on the overall trend. When the trend is up, you want to belong, and when it’s down, you want to be on the sidelines.

Identifying a trend is not easy, but one very simple approach is to use a moving average. You want to be in the market when it is about an average like the 50-day and out of it when it is below it. There will be choppiness at times, but if you use longer-term time frames, the trends are fairly clear.

Here is an example using a 5-day chart of the SPY and the 50-day. If you had sold every time the S&P fund (SPY) broke under the 50-day and rebought when it recovered that level, then you would have missed substantial portions of every bear market. However, there are times when there will be false signals, and it is necessary to rebuy at higher prices, but that is the cost of risk management. Overall missing out on the huge drawdowns is well worth it.

It is extremely important to note that this only works if you are equally aggressive at rebuying when the 50-day level is recovered. Most people fail to do that, which is why market timing does not work for them.

This is an illustration of one simple market timing approach. No predictions or analysis is needed. It is a mechanical system, and it won’t always work very well. One added benefit is that you will never rebuy a stock that doesn’t recover its 50-day simple moving average, and that may be a good thing.

Market timing isn’t rocket science. It is simply a way to navigate the inevitable cycles of the market. As long as you are ready to rebuy positions that you have sold, there is a little downside to it.

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