A market timer can help you manage your investment portfolio by protecting against major losses. It does this by telling you to sell your stocks when major bear markets are in the making – the kind of losses that may take many years to recover from.
There’s a saying in the investment community that goes like this: if you can get most of your money out of the market when things are bad, then you will do very well over the long term.
In other words, the idea is to skip most of the damage caused by a bear market, and stay in the market the rest of the time. It’s about ensuring that you don’t get hurt too badly when the inevitable downturn happens. It’s also about appreciating the value of cash when all hell is breaking loose in the market.
The idea then goes further by prompting you to get back in when your timer tells you to do so. Getting back in the market when everything is beaten up is a powerful way to further boost your portfolio returns. Think of a kid in a candy store.
Difficult To Do in Practice?
In principle, the idea of selling during a bear market makes a lot of sense. In practice however, it can be quite difficult to implement. Emotions usually get in the way, and so investors tend to sell too late after most of the damage is done. And to make a bad situation worse, they often lick their wounds for too long after suffering big losses, being scared to go back in while the market makes its comeback. This means they miss out on the spectacular recovery that usually happens shortly after a painful bear market.
In other words, emotional investors without a system do exactly the wrong thing: they sell low after they can’t take any more pain, and then buy back at a (much) higher price later on. Sounds familiar? I know, I was one of them during the tech bubble and bust 15 years ago. It’s not a fun place to be.
This typical behavior is the reason why most investment advisers recommend to close your eyes and ride out market downturns instead of trying to “time the market”. This also makes sense. For an emotional investor, following this advice is usually (but not always) a better scenario. But for the rest of us, it’s worth asking the obvious question: is there a better way?
Clouds on the Horizon
Consider this for a moment:
Q: You are outside and you see dark clouds on the horizon. What do you do next?
A: You pack up your stuff and go hide somewhere while the storm passes.
Similarly, when the birds start chirping and the rain has stopped, you consider going back outside. There may still be some clouds around, but the storm has passed so you risk it and you go back outside.
A market timer does the same thing for your investment portfolio. It’s a market storm indicator. It helps you decide, without emotions, when it’s time to consider packing up and go home, and when it’s time to risk it and start going back in the market. A simple, yet very powerful idea. The key is that it helps you achieve this without your emotions getting in the way.
A Market Timer is Not Timing the Market
Timing the market is very different from using a market timer. Timing the market is about trying to time the monthly or quarterly swings of the market by attempting to buy low and sell high. Whenever the market goes down a bit, you buy. Whenever the market goes up some, you sell.
At best, this is very hard to do even for the professionals (although not impossible). One of the key challenges with timing the market is that you could be selling at a time when the market is about to run much higher for several months or even years, so you miss out on all these gains. Similarly, you could be buying after a small correction, just to see the market nosedive from there by another 30% or even 40%.
I’m very sorry to say, but timing the market is indeed one of the toughest games to play and win.
Using a good market timer, on the other hand, gives you a signal once every few years. It helps identify the major bear markets, as they start to happen. A good market timer couldn’t careless about the run-of-the-mill corrections. For example, during the last 20 years, a good timer would have told you to be in cash only twice. First, during the 2000 – 2003 bear market (-78% on the Nasdaq, -49% on the S&P 500), and second, during the 2008 – 2009 financial crisis (-56% on the Nasdaq, -57% on the S&P500).
To illustrate, look at these charts. Assume today is February 2000.
Would you sell your stocks right now? If you’re a mortal like the rest of us, your emotions would tell you not to sell any. In fact, you’d probably buy more. Things are going awesome, and you’re having fun and making a ton of money. You’d justify the little dip in early 2000 as just another correction and most likely, an excellent opportunity to “buy the dip” as the saying went in those days.
Now look at this chart:
Oops! Apparently you should have sold while the party was going strong. If you “bought the dip” earlier, hopefully you didn’t do it by borrowing on margin!
And That’s the Value of a Market Timer!
It helps you to get out during bear markets, and to be boring the rest of the time by staying invested and enjoying the market gains. By skipping most of the downside of major bear markets, you seriously end up boosting your long term returns. And as a bonus, you also sleep much better at night. 🙂
In the next post, I will analyze a popular market timer called the Golden Cross.