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Market Timing: is it an appropriate strategy?

Vik Mehrotra

Several investors try and use mutual funds (particularly, index funds) asa way to time the market. However, history has shown that market timing does not improve performance results over a long period of time. No one can consistently outperform the benchmark indices by timing the market. The best investors and the richest ones are known to hold on to their stocks for several years and sometimes even decades. There are a lot of short term traders in the market who make money sometimes and lose an even number of times but in the end their results are lower when compared with a simple buy and hold strategy. Market timing also entails the risk of miscalculating and hence, missing out a rally. This could significantly reduce long term returns.

History has shown that every time the market has gone down (due to war, recession or any other reason) it has always come back and made a new high. Hence, long term investors should not time the market but add aggressively when the market is low. I remember that many mutual fund investors pulled their money out of the market when US was going to attack Iraq but to their surprise the successful offensive made the market go up and not down. A market timer risks the possibility of missing the best up days. It is best that investors do not try and time their purchases into mutual funds but instead use a dollar cost averaging methodology to minimize their timing risks. Dollar cost averaging simply means that an investor should buy the same (or different) mutual funds slowly and spread the purchases over a period of time, which may depend upon the age, goals, and the investment objective of the investor.

An ideal solution is to continuously add extra money into a few mutual funds in a pre-determined ratio on a monthly basis without paying any regard to the level of the market. In the long run, this strategy will produce good returns, as the strict discipline will not let the emotions of the investor take wrong market timing decisions. The dollar cost averaging will eventually over a period of several years add a significant amount of money to a person's net worth. A small investor can use this strategy by contributing as little as $100 a month into a mutual fund. To give an idea of the potential by using this strategy, take an example of an investor who adds $100 a month for 30 years in a blue chip growth stock fund to plan for his retirement. Assuming a 12% annual return (which by historical standards is not high), the investor will end up having $350,000 in savings. Hopefully, the fund manager will be buying and holding securities and most of the gains will be long term capital gains as opposed to ordinary income. It is advisable to find a fund, which has a low turnover of stocks. In this example, the investor is putting up only $36000 over 30 years, which is becoming $350,000. Now imagine if the investor has $36000 as of today and can drop all of it into a mutual fund which earns 12% a year for the next 30 years. This investor will end up amassing over $1 million during the 30 years.

In general history has shown that equities tend to do better than fixed income securities over a period of long term. The blue chip equities have on average returned 12.9% per annum over a period of last 73 years as compared to a 6.5% return in the corporate bond and 4.5% in the government bonds category. For an average investor, mutual funds are a great way to accumulate long term savings. However, they require patience and discipline of dollar cost averaging ignoring the fluctuations in the stock market. An investor needs to be focussed on the long-term results of investing through mutual funds in order to make the strategy work.Not all mutual funds are alike and the selection of the correct ones based upon an investor's investment objectives is a must.

(Vik Mehrotra, Venus Capital, Boston, is a Registered Investment Adviser with SEC and manages India Technology Fund and is a managing partner at venture capital firm, Voyager VP. )

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