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Using Investors' Emotions to Time the Stock Market? Yes, You Can

NEW YORK (TheStreet) -- Trying to time the market is a fool's errand that will end up costing you time and, more importantly, money in the form of trading costs, taxation on capital gains and the prospect of being un- or under-invested on up days.

At least, that's what proponents of the "buy and hold" strategy and executives at indexing firms like Vanguard advocate. Their argument, which draws a lot of water, is that the highest-paid mutual fund managers cannot "beat their respective index," after fees and expenses, with any degree of regularity.

Ok, that's fine, but we in the advisory world have clients to whom we report. And clients have these pesky things called "emotions."

Not everyone is comfortable plowing the majority of their net worth into something like the S&P 500 Index Fund (VOO). Plus, an index fund mimicking the performance of the S&P is unlikely to meet a high net worth client's objectives.

What if a client's primary objective is to "feel safe," or to "not take too much risk," or to "never lose more than 10% in a given year"....? Every client has different needs, and therefore every client should really have a different benchmark against which one can evaluate his portfolio. It's ignorant to think no measure of market timing is necessary to successfully manage money.

Can we time the market using investors' emotions as indicators? This is called behavioral finance, and I find it fascinating. But first we need to recognize that there is, in fact, an emotional cycle around which investors operate.

Where are we today in terms of the market's emotional cycle? Consulting the graphic below, I feel like we rounded the base of "optimism" sometime last year, with 2013 culminating in a stage of "excitement." If I'm right, then we are mid-"thrill" which, in itself, is pretty thrilling.

Courtesy of Northwestern Mutual

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Chart of I:DJI
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