What it is:
How it works (Example):
Let's assume you have $100,000 to invest. Based on your circumstances, risk aversion, goals, and tax situation, you put $50,000 of the money in stocks, $30,000 in bonds, $10,000 in real estate, and $10,000 in cash.
The market timer seeks to sell at the "top" and buy at the "bottom." Thus, if interest rates increase, the market timer may sell some or all of his stocks and purchase more bonds to take advantage of what may be a "peaked" market for stocks and the beginning of a boom for bonds.
Market timers believe short-term price movements are important and often predictable; this is why they often refer to statistical anomalies, recurring patterns, and other data that supports a correlation between certain information and stock prices. A market timer's investment horizon can be months, days, or even hours or minutes. Passive investors, on the other hand, evaluate an investment's long-term potential and rely more on fundamental analysis of the company behind the security, such as the company's long-term strategy, the quality of its products, or the company's relationships with management when deciding whether to buy or sell.
Market timers are more likely to use leverage in order to produce better results. This in turn introduces more risk into their portfolios but may also provide higher returns.
Why it Matters:
In general, the constant analysis associated with market timing involves more asset re-allocation and trading activity than passive management. It often also requires more time and education than passive management, and the extra trading commissions and capital gains taxes may translate to higher management fees and return requirements.
Market timing is a controversial idea. Many studies over the decades have found that many managers cannot find the market's "tops" and "bottoms" consistently. But the most notable areas of controversy are theoretical rather than mechanical. Many passive managers dislike market timing because they espouse the efficient market hypothesis, which says that prices are random and already reflect all available information. A cousin of this hypothesis, the random walk theory also claims it is impossible to consistently outperform the market, particularly in the short term, because it is impossible to predict stock prices.
Regardless, market timing enjoys a large and loyal following among investors, and many active managers have posted returns well above market benchmarks. However, consistently providing above-average returns remains the big challenge.
No matter where they rest on the issue, most analysts encourage even passive investors to learn about and understand market timing methods, stay current on their investments, and know how to read stock charts.