Does Market Timing Work?

In last Friday's article of SCI Daily - 6 Tips for Timing Your Investments , I discussed a few considerations to help you decide when to enter and exit stock positions. Let's continue with the timing aspect of investing today.

Timing is rarely perfect, even when you know the signs to look for and you think there will never be a better moment to buy shares. So if trying to achieve perfection is a fool's game, I say why bother? Better to realize perfection is near impossible, and simply strive for an average share cost basis that is close to perfect.

With this mentality, you can control your overall cost of buying stock by using averaging techniques.

***Dollar cost averaging is a technique in which the same dollar amount is invested in one company at regular intervals-monthly, for example. An analysis of the effect of this technique is that the average price is higher than the current price in a falling market, but it is always lower than the current price if the stock price is trending higher.

For example, say you buy $1,000 of stock in six consecutive months. During that time, the price trends downward:

Note that dollar cost averaging in this example creates an average purchase price (the fourth column) per share that is always higher than the current market value. At the end of six months, if you were to sell all your shares, you would have a much smaller loss than if you had purchased all of your shares at the initial price of $14.15.

Dollar cost averaging when the stock's price is moving upward creates the opposite effect - and naturally this is what we want. Your average price is always lower than the current market value. For example, given the same facts as above but in a rising market:

In this scenario your average cost per share is $14.62 after six months. Your average price is higher than it would have been if you had purchased all shares in the first month, but the system is designed to protect against price decline.

But what is not shown in these tables are the actual returns for each stock purchase. In the second scenario, you would have capital gains over each period, so you would be sitting on an overall positive return - without the risk of buying all shares at once.

More often than not, a stock doesn't move steadily upward or downward. So dollar cost averaging can help to smooth returns and allow you to take advantage of weakness to accumulate shares at a good value.

***A similar technique is called value cost averaging. In this variation, the dollar value of monthly share purchase is adjusted based on how the stock performs. When the price declines, you buy more shares, and when the price increases you buy fewer. This creates the overall effect of an average basis below current share price. It also improves your average rate of return when the price does increase well above your average cost basis.

When using averaging techniques for buying stocks you can worry less about timing and more about growing profits over the long-term. Timing is an important issue because naturally you want to buy low and sell high. But if you are looking to the long-term and plan to hold your small cap stocks as both growth and value portions of your portfolio, short-term timing is not as crucial an issue as the more critical stock selection itself.

***You have a lot to think about as an independent investor. You have to master an array of different kinds of orders and decide which work best for you; identify the threats and determine your own risk tolerance. Most of all, you have to time your buy and sell decisions to make the best use of capital, avoid loss, and maximize your profits. All of these challenges rely on experience - and selecting the best sources for information for research.

***My book, The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks , is filled with every tip and trick I know about investing in small-caps, and I think it's absolutely vital to anyone interested in the topic. There is a ton of great information in the book, and it is a great compliment to Small Cap Investor PRO .

I'd like to give you a free hardback copy when you join Small Cap Investor PRO . Click here to get the full details.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics


Latest Markets Videos