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"You knew the market was going crazy. How could you have missed the signs?"
"If you had sold last week, then bought those same stocks back on Tuesday, your portfolio would be up 50% instead of down 20%."
"Next time you see the market running up like that, sell! Sell! SELL!"
Where's that Haldol?
Market timing has to be one of the most seductive investing ideas out there. It's pretty obvious that if you buy when the market is about to go up and sell when the market is about to go down, then buy again when it is about to go up... you will easily beat the market.
Say you owned something simple like Spider's <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %>, the S&P 500 index shares. Spider's haven't been doing all that well for the last year -- compared to recent years, anyway. After five calendar years of 20+% growth, they are up about 15% over the last 12 months. But if you had bought them one year ago at $135 and sold them last July when they were up around $140, then used your profits to repurchase them in September when they were down to $125, your portfolio would be up 33% right now, with them at $155, instead of 15%.
If you can time the market, you don't need to do all that messy research into balance sheets or mechanical models. In fact, if you just know someone who can time the market, and who is willing to tell you when to buy and sell, then you don't need to do much of anything except place orders and spend the profits.
Yep, market timing is a seductive idea and lots of people know it. In fact some very smart people have figured out how to profit from market timing. Here's how it works:
Buy a good mailing list, about 100,000 e-mail addresses. Send out 100,000 e-mails touting your market prediction system and offering to prove yourself for free. Give your first prediction: 50,000 e-mails get a buy recommendation, and 50,000 get a sell recommendation.
Next week, figure out which of those recommendations was right. Toss the addresses of the people that got the wrong advice, and send out two more predictions to the 50,000 that got the good advice. Half get buy recommendations, half get sell recommendations.
The next week you send out 25,000 e-mails, half get... you get the picture. After three weeks you have 12,500 people who have received three correct predictions in a row and they are thinking, wow, this guy must be on to something! You write a very elaborate letter describing your complex prediction system and illustrating just how much money they could have made had they followed your advice, and tell them the NEXT prediction will be included in your new newsletter if they would like to subscribe at $250 per year. If five percent of them bite, you pocket over $150,000.
What am I doing working for a living?
Oh, yeah, ethics. And those pesky fraud laws.
The point of the illustration is not to suggest that anyone has actually done this (or, god forbid, to suggest trying such a scheme to the less ethically handicapped), but to show you how easy it is to appear to be good at calling the market.
The other way to do it is to simply use the laws of probability. Put 100 people in a room (say a broker's office) and ask them to predict the short term direction of the market. About half of them will be right the first time. Keep them and kick the rest out. Ask for another prediction. Twenty-five (more or less) will be right twice in a row, twelve will be right three times in a row, six will be right four times in a row, three will be right five times in a row, and one will become a Vice President who's every utterance is treated with hushed reverence by the Wise.
With a good education and a sophisticated system for predicting the market including interest rates, inflation, Gross Domestic Product numbers, temperature samplings from the South Pacific and that great track record, one can make a pretty good living selling financial advice.
But not to you, I hope.
By the way, I'm not claiming that market timing is impossible. Who knows? In fact I just read a fascinating book called The Predictors about a group of physicists who appear to have developed computer models that can make very short-term predictions about various stock and commodity prices. They are making a ton of money, in fact. But they make money by using their models to trade, not by trying to sell their predictions to the public, which would bring in far less money and undoubtedly wreck the models.
Thanks to the guys at last weekend's Mechanical Investing Convention for the e-mail example above. Kinda makes you wonder about how their minds work!
Fool on and prosper!