What is market timing, and should you do it?

In my previous post, a few commenters brought up the issue of market timing, generally taking me to task for appearing to advocate it. Market timing is a topic of much discussion, primarily in the world of stock investing. With this post, I hope to explain the issue and show how it applies to you, even if you never invest in a stock or mutual fund.

What is market timing?

The oldest investing advice in the book is "buy low and sell high." Market timing is an attempt to do just that: Sell when the market is high; buy when it's low. Obvious, right?

Obvious, though, is not the same as easy, because market timing, in essence, entails predicting whether the market will keep going the way it's going, or make a turn, up or down, which is easier said than done.

Let's say you wake up one morning, and this is the picture you see of a stock you've owned for about five years. (The chart is real, drawn from Yahoo Finance, but the name of the stock, and the dates, have purposely been blanked out, because most people's first instinct will be to draw on historical knowledge to guess the outcome.)

Sell… or hold?

The stock has doubled in value in the five years you've held it. Hey, double is high, right? So should you sell today?

Answer: You don't know. You don't know if double is high enough or if you should hold the stock in hopes of more gains. Thousands of investors bought Microsoft at $1x, and felt good when they sold for $2x, only to see it go to $10x after they sold. On the other hand, many held AOL at $2x, hoping for $10x, only to see it drop to less than $1x.