Market timing is one of the least understood concepts involved in investing money. It’s time we identify and debunk some of the myths about market timing. These myths seem to take on a life of their own through repetition. But anybody interested in market timing deserves to know the truth, and this seems like the perfect time for a refresher course.

MYTH #1: "Unless you are in the market all the time, you’re in danger of missing the very best days, and those relatively few days account for a huge portion of the stock market’s gains."

REALITY: This is an easy trap to fall into, usually backed by citing statistics over a particular market period. For example, if you invested $100 in the stock market in 1926 and simply kept your money there through 1993, your investment would be worth $80,000. But if you tried to time the market and "missed" the 30 best months, your $100 would have grown to only about $1,200 the same return you would have received investing in U.S. government T-bills.

THE BEST VS. THE WORST

That may sound convincing at first glance. But why don’t the critics of market timing also talk about the 30 worst months in those 67 years? Successful investing isn’t just how you do in the good times. Avoiding the awful times is at least as important as "being there" for the best times. So what if market timing kept you in the market all the time except for the 30 worst months from 1926 through 1993? This is pretty hard to believe, but your $100 initial investment would have grown to around $8.6 million. (I wish I had a system that would do that, and if I ever find one, readers of the FundAdvice.com will be the first to know about it!)

If you really must play such what-if games, ask what would have happened to a $100 investment if it had missed the 30 best and the 30 worst months. With all the disasters and all the thrills removed from those 67 years, a $100 investment would have grown to $120,000, and with a lot less anxiety.

The myth of "missing the 30 best months" also assumes a patient investor who started in 1926 would serenely and faithfully endure the S&P 500's 85 percent decline that started in 1929 and the small stock index's 70 percent decline in 1973-74. I have met very few investors in real life who would do that.

If you want a guarantee that you’ll never miss the very best days of the market, you’ll get it with buy-and-hold. But the guarantee comes with a heavy penalty, because in the worst times, you’ll have to watch your gains vanish.

MYTH #2: "You don’t need market timing when things are bad. Just be patient and wait for the market to come back, and all will be fine."

REALITY: Mathematically, over very long periods of time, that has proven to be true. If investors had infinite patience and if they never needed their money in the meantime, such an approach might work.

Over the years I have asked thousands of clients and potential clients to complete a brief questionnaire about their investment needs and risk tolerance. I ask how large a one-year loss they would be willing to tolerate in order to achieve a potentially greater long-term gain. In thousands of responses, more than 90 percent checked the box marked "less than 10 percent."

Simply waiting for the market to "come back" produces big paper losses that may last for years, along with a lot of anxiety that could be avoided with the judicious use of market timing. Is it fair and realistic to expect investors to endure devastating losses, even if those losses are temporary? I don’t think so.

IS EVERYTHING JUST RANDOM?

MYTH #3: "The movements of the market are random. They can’t be predicted, and the market cannot be timed."

REALITY: There is no way to prove for sure whether this argument is right or wrong. But I don’t buy it. The stock market is driven by forces such as optimism, pessimism, fear, greed and expectations for the economy. These forces are constantly evolving. But very often they persist long enough to keep shoving the market in a particular direction. And quite often this provides great opportunities to sell securities before a decline devastates their value and buy them back later at lower prices. That’s what we try to do.

Sure, there’s a danger of being whipsawed back and forth by false signals. Our systems are designed to minimize this type of activity, but if you’re going to use market timing, you should know in advance that not every buy or sell signal will turn out the way you thought it would.

MYTH #4: "If market timing really worked, everyone would do it."

REALITY: Surely you jest! You could say the same about dieting, exercising, obeying laws, paying bills on time – or saving money for retirement! All those things unquestionably make life more workable. So why don’t more people do them? Most of the reasons are psychological, and they apply to investing, too. Let’s look at a couple of examples.

FORBIDDEN FUDGE

Many people don’t diet or exercise successfully because it’s so hard to resist temptation. Just a little fudging (or fudge) here or there won’t ruin an entire eating plan, they tell themselves. The same holds true of market timing. Whenever a timing system gives you a buy or sell signal, the temptation is always present to second-guess that system, especially if you "know" something the system model doesn’t. I have talked to many timers, and I have yet to find one (including myself) who hasn’t yielded to that temptation at least once and later wished he had just followed the system. The problem is, eat one piece of forbidden fudge and you don’t gain five pounds, so it feels just fine. Tamper with your timing system once, suffer no major consequences, and you can convince yourself that your intuition is smarter than the system. Soon there’s no system at all, just you, doing your thing.

Most investors don’t accept the type of market timing we do because it seems too simplistic. People who read The Wall Street Journal every day and study the market and the economy feel insulted by a technique that seems to make a mockery of all they know. You will often be at a loss to give yourself or anybody else a convincing reason why you just bought or sold. The reason, "because the system said to switch," rarely meets the needs of those who enjoy following the economy and the market.

Professional money managers shy away from market timing for several reasons. Most of the people in this industry do not want to face the daily responsibility of market timing. They don’t want to have to explain timing to their colleagues, peers and clients, especially when those systems require managers to be on the sidelines during any part of a market rally.

If you are a traditional investment manager you can stand by and watch your clients lose 30 percent of their money, then explain that it happened to everybody. Chances are your clients will stick with you. But stay on the sidelines during a couple of Wall Street’s big "thrill" days, and your phone will start ringing off the hook with clients wanting to take their money elsewhere.

Some managers and investors don’t like market timing because it interferes with their commitment to the concept of "buying value." If you decide to buy a stock for $50, you’ll likely have plenty of reasons to believe it is "really worth" substantially more. What happens when it drops to $40? A good market timer will simply note that (for reasons that don’t really matter) the market is down and he wants out. But the investor who has "married" a certain security is likely to remain convinced that it’s really worth $75. Sometimes they’ll even buy more at $40, $35, $30 etc. I'm not saying their commitment to buying and holding undervalued securities is wrong, I'm just not comfortable with that approach for my own or my clients' life savings.

FEAR OF FAILING

Finally, there’s the fear of mistakes. In this business, mistakes are guaranteed. Market timing requires making a lot of moves in and out, and some of those moves will turn out to be wrong. Many people have an awful time dealing with their mistakes. History tells us one of every three trades will lose money, and half the time investors will buy back into the market at a higher price than they last sold. Most people simply don’t have the psychological fortitude to stick with such a system. Two losing trades in a row, even if the losses are small, will turn many people away from market timing permanently.

MYTH #5: "Market timing is a riskier way to invest than buy-and-hold."

REALITY: Yes, market timing is a real risk to fragile psyches, big egos and investors who can’t stick to a discipline. But as we have pointed out repeatedly in these pages, backed with ample data, when market timing is followed as a discipline, it does not put investment dollars at added risk.

For purposes of this discussion, let’s say there are two primary kinds of investment risk. There’s the risk that you could lose a significant part of your money in a down market. And there’s the day in, day out volatility that erodes investors’ comfort and leaves them with paper losses that reduce their ability to take out their money should they need it unexpectedly. In both cases, market timing reduces those risks. Over the past 11 years, our timing systems have reduced the volatility of stock market investments by about 50 percent. In addition, we have substantially reduced investors’ exposure to bear markets, being in cash about 40 percent of the time.

CAN YOU TAKE A VACATION FROM MARKET TIMING?

Market timing is risky for investors who try to do it themselves. It’s a daily responsibility from which you never take a vacation in the true sense of the word. You have to watch the market and be prepared to take action every single market day. Yet many investors simply drop the ball when it’s time to go on vacation, and I can’t blame them. However, that is what I would call a high-risk way to do market timing, and it’s one reason I believe smart timers will always have somebody else make the moves for them, automatically.

When do-it-yourself market timers ask me what to do when they can’t tend to their investments, I suggest they switch to cash while they’re gone, then pick up the system when they return. However, that’s not very good advice, as it violates the rules of a timing system by inserting trades based on personal convenience instead of the dictates of the system.

MYTH #6: "Mutual fund managers will take care of any timing decisions that are necessary."

REALITY: I say that’s baloney. Yes, mutual fund managers pay attention to the prices at which they buy and sell securities, and in that respect they try to buy at the right times (when prices are low) and sell at the right times (when prices are high). But this is completely different from what we do, moving much or all of your money in and out of the market.

Most mutual fund managers remain committed to the type of asset they own regardless of their view of the market. In many cases, they carefully accumulate a stock over several months to avoid driving up the price. They are not likely to ditch that stock for timing purposes. Fund managers see a market decline as an opportunity to buy more of the stocks they like. Market timers see a market decline and conclude they should sell their portfolios in the hope that they can avoid major losses and reposition themselves in the market at lower prices.

MYTH #7: "For market timing to work, you have to be right 70 to 80 percent of the time."

REALITY: It isn't how often we're right that's important, it's the size of the gains and losses. Applying the four systems we use for timing the U.S. stock market to the Lipper Growth Fund Index, backtested to 1972, produced losing trades about one-third of the time. The average loss was -2.8 percent and the average gain was 16.6 percent.

Another example is our record with United Services Gold Shares, a fund we have been timing since 1983. Six of every 10 moves we have made in that fund have been losing trades, yet our cumulative record is splendid. Buy-and-hold investors in the fund lost nearly 40 percent of their initial investments in 10 years. Those few who moved in and out of the fund with our timing system more than doubled their money in exactly the same period. This shows that market timing, properly done over a long period of time, can truly turn a lemon into lemonade!

DO-IT-YOURSELF MARKET TIMING

Many people think timing the markets must be a very complex process that requires using computers and predicting the future. One criticism I hear often is: "Nobody can predict the future." In fact, I agree! I don’t trust market timers, or economists either for that matter, who claim to see into the future. And as readers of our newsletter know, all the timing we do for clients is based on reacting to present trends, not predicting the future.

Although we use numerous timing models that track quite a few individual funds and market indexes, market timing doesn’t have to be complicated. I’m about to describe a timing system that doesn’t require a computer, a crystal ball or economic analysis. All you need is a bond fund and a notebook in which to keep track of the fund’s price. This may be useful for somebody who wants to try out market timing on a do-it-yourself basis. And if you’re not quite sure if market timing is really safe and you want to see how it works in real life, even without committing money, this system is an easy way to dip your toe in the water.

Here’s how to start: In your notebook, start recording the price of your chosen bond fund every day, always keeping careful track of the lowest price you have recorded. When the fund reaches 2.5 percent above that low, consider that you have received a "buy" signal – and invest in the fund. Now you are "in" the market, hoping the upward price trend continues.

Keep recording the fund’s price every day, but this time make a note of each new high price. When the fund price drops to 97.5 percent of its highest price since you bought, you have a "sell" signal. Move your money into a money market fund. Now start the cycle again, and buy back into your bond fund when it reaches 102.5 percent of the lowest price since you last sold.

Be sure to adjust for month-end dividend distributions and year-end capital gains distribution. For example, if your bond fund has declined 2 percent since you purchased it, a month-end distribution of one-half of one percent will trigger a sell unless you adjust for the distribution. The easiest way to keep track of the distribution is to deduct the dividend from the most recent high price and watch for the 2 1/2 percent decline from that adjusted price.

This is a very simple system, and you can easily see that it doesn’t take any forecasting ability. It simply tries to identify existing price trends and either ride them up or sit them out. Like all market timing systems, this will produce some losing trades. You’ll sometimes buy at a higher price than your last sale, and sometimes you’ll be on the sidelines when the market is going up. If you’re human, there will be times you will want to second-guess the system. But if you follow it without question over a period of years, you’ll likely improve your return and reduce your risk, as I will show in a moment.

DON’T BE A SISSY

Normally, bond investors are conservative by nature and try to avoid volatile investments. But for this system, we advocate striking out aggressively and using bond funds that invest in high-yield bonds or long-term government or corporate U.S. and international bonds. (If you try this with a short-term bond fund, you may wait forever for a buy or sell signal!) Also, make sure you can exchange your money in and out of your chosen bond fund without a penalty.

In my new video, How To Succeed At Mutual Fund Investing, I show how this simple market timing system improves the return on the Vanguard High Yield Bond Fund and the T. Rowe Price International Bond Fund. Over a seven-year period this simple market timing discipline brought significantly higher returns to both funds, while reducing those funds’ volatility by about 40 percent.

Using actual fund prices from 1987 through 1993, I have put the crucial comparisons in a table below. For each fund you’ll see the compound rate of return for a buy-and-hold investor and the amount that $10,000 would have grown to. Then you’ll see the same information for investors using this timing system.

And because timing is designed to reduce volatility, we also show the number of losing quarters and the cumulative results for the worst four consecutive quarters in that seven year period. I think you’ll be surprised to see the dramatic difference of market timing versus a buy-and-hold on the worst 12-month period an investor in those funds had to live through with each discipline.

In each case, market timing increased an investor’s yield while sharply reducing risk. The last two lines in the table are at least as important as the first two. Most investors buy bonds to stabilize an investment portfolio -- and market timing added stability.

EARN $940 AN HOUR AT HOME IN YOUR SPARE TIME

Investors who timed the Vanguard Fund wound up with $3,040 more that those who bought and held. How much work did it take to earn that extra $3,040? About two minutes a day to record the fund’s prices, plus perhaps an hour a year to make trades and keep tax records. That’s about 6.5 hours to make $3,040, or about $470 an hour. If you started with $20,000 instead of $10,000, your per-hour return would be $940. Where else can you earn that kind of money, at home in your spare time, while you enhance your peace of mind?