Market Timing

Market timing is the practice of moving into and out of an investment according to a view about what the market is about to do, rather than staying invested through the movement. It is one of the two bets that define active investing, the other being which securities to own, and our pages on active and passive investing cover the stance those bets add up to.

The word carries a second meaning that most readers meet without being told it is a different subject. In fund regulation, market timing describes rapid purchases and redemptions of fund shares intended to exploit the way fund prices are struck, a practice that increases costs for the shareholders who remain. That usage is the reason a mutual fund prospectus contains a section headed market timing or frequent trading, and a reader who meets the phrase there is not being addressed as an investor with a forecast. They are being told what the fund will do if they trade in and out of it.

The two senses are related only by the words. The first is a strategy an individual might attempt with any investment. The second is a category of conduct a fund is required to have a policy about.

The structural problem with timing is the count of decisions, and it is more demanding than a single call about direction. Getting out is not a position, it is half of one. The money has to go back in, at some price, on some date, and the outcome depends on both choices. So the investor is not making a call about whether the market will fall; they are making a call about whether it will fall and a second call about when it has finished falling, and the second is graded against the price they sold at rather than against zero.

The two decisions are also not made under the same conditions, which is what makes the second harder than the first. The decision to sell is usually made when the news is bad and the case for selling is easy to articulate. The decision to buy back has to be made while the news is still bad, because a recovery is only visible in hindsight and prices move before the reasons for them are clear. So an investor who exits successfully has bought themselves a decision that has to be taken with less confidence than the first one, and taken at a specific moment rather than eventually. Our page on panic selling covers the version of this that happens involuntarily, where the sale was prompted by the price rather than by a plan.

On the question of what timing costs, this page states the disagreement rather than a number. Estimates of how much investors give up in aggregate through the timing of their purchases and sales vary widely among credible sources, including sources examining the same underlying data, and the authors of the best-known measure caution against reading it as evidence of individual investors' fallibility. Where credible sources disagree on a key figure, this site publishes neither version. The structural argument above does not depend on the magnitude, and the arithmetic below can be checked by anyone.

The second meaning, and the rule behind it. Mutual fund shares are priced once a day at a value calculated from the fund's holdings. Where some of those holdings last traded hours earlier, a trader who buys or sells after information has emerged but before the next price is struck can transact at a price that no longer reflects reality. Any gain that produces comes out of the fund, and therefore out of the shareholders who did not trade. That is dilution, and it is the harm the rules address.

What the rule actually requires, which is a board decision rather than a fee. Under 17 CFR 270.22c-2, it is unlawful for a fund to redeem a redeemable security "within seven calendar days after the security was purchased" unless it meets three requirements. The fund's board, including a majority of directors who are not interested persons, must either approve a redemption fee, "in an amount (but no more than two percent of the value of shares redeemed) and on shares redeemed within a time period (but no less than seven calendar days)," judged necessary or appropriate to recoup the fund's costs or reduce dilution, or determine that a fee is not necessary or appropriate. The fund must also enter into shareholder information agreements with the financial intermediaries that submit orders, or prohibit those intermediaries from purchasing in nominee name, and it must keep records of those agreements. So the requirement is a board determination plus an information trail, and the two percent is a ceiling on a fee the board may choose not to impose at all.

Three categories of fund sit outside that requirement, unless they elect to impose a fee anyway: money market funds, funds whose securities are listed on a national securities exchange, and funds that affirmatively permit short-term trading of their shares where the prospectus discloses clearly and prominently that they do and that such trading may result in additional costs for the fund. The second of those is why an exchange-traded fund is treated differently here from a conventional mutual fund.

The practical reading for someone holding a fund. The frequent trading policy in a prospectus is not advice about strategy and does not indicate the fund's view of the market. It states what the fund will do if an investor's trading pattern looks like the conduct described above, which can include refusing an order or restricting an account, and whether a redemption fee applies to shares sold soon after purchase. Those are terms of the holding, and they are worth reading before selling a position bought recently.

An investor forms a view that prices are about to fall, sells, holds cash, and later forms a second view that prices have stopped falling and buys back. The result compares the price sold at with the price bought back at, net of any tax on gains realized in the sale and any income given up while out of the market.

A hypothetical illustration of why one correct call is not enough. Start with an investment worth $100. Simone judges that prices will fall and sells at $100, which turns out to be right: the market falls 15%, so the same investment would have been worth $85.

She waits for confirmation that the decline is over. By the time the evidence looks convincing the market has risen 25% from the low, which puts the value at $106.25 ($85 multiplied by 1.25). She buys back there. She sold at $100 and repurchased the same investment for $106.25, so she is 6.25% worse off than someone who did nothing, despite having called the fall correctly.

Change one number and the result flips. If she had bought back after a 10% rise from the low, at $93.50, she would be ahead by about 6.5%. Both decisions had to work, and the second one required buying while the market was still 6.5% below where she sold. Tax on any gain realized in the original sale is ignored here and would make every version worse. All figures are illustrative.

Pros

• Being out of the market during a decline avoids that decline, which is the entire appeal and is real when the timing works.
• A rule that reduces exposure at defined points can help an investor stay invested at all, which is worth more than the theoretical optimum they would have abandoned.
• Reducing exposure for a reason unrelated to forecasting, such as an approaching need for the money, is not market timing and is ordinary planning.

Cons

• Two decisions must be right rather than one, and the second is made with less information than the first.
• The re-entry decision has to be made while conditions still look poor, which is the point at which conviction is lowest.
• In a taxable account the exit realizes gains, so tax is paid for the privilege of attempting it.
• Income and distributions received by holders are given up while out of the market.
• Trading a fund frequently can trigger the fund's own frequent trading policy, including a redemption fee or a restriction on the account.