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Market Timing: Empirical vs. Emotional
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MARKET TIMING: Empirical vs. Emotional
 
Market Timing Overview
Market timing is the universal attempt to predict future market trends and to consequently profit from these trend predictions. The attempt to "buy low and sell high" represents the core of all investment decisions and varies from investor to investor most conspicuously in its tactical scope, including the decision to cash out of current holdings and/or to move from small-cap stocks to large-caps, from value to growth stocks, from financial stocks to Internet stocks, from stocks to bonds, or from mutual funds to ETFs and so on.

Market timing also varies from investor to investor in its analytical complexity, ranging from an empirical, objective approach to an emotional, subjective approach. Both approaches represent opposite endpoints along an investment strategy continuum: empirical approaches entail a systematic examination of recent price, volume and/or other economic data, whereas subjective approaches navigate on hope, greed and/or fear. Most typically, market timing represents a combination of the two approaches, where predominantly empirical techniques (i.e. that assume a relatively lighter emotional component) are unsurprisingly less prevalent than their predominantly emotional counterparts (i.e. that assume a relatively lighter empirical component).

As examined in the following sections below, a purely empirical market timing approach that directly examines market behavior as an end in itself and excludes all other overlapping and/or derived empirical and emotional techniques (e.g. including so-called "mechanical" approaches whose notable reliance on automated algorithms, which at their best, serve only as indirect indicators of market behavior) will on average outperform the current set of heterogeneous empirical and emotional timing approaches given the following:
 
The more intricate and accurate the description of underlying market behavior The greater the ability to predict its behavioral variations The greater the yearly return on investment

Empirical Timing
Suppose that the stock market over a period of time sustains a hypothetical sine wave chart pattern as shown in Figure 1 below. A purely empirical market timing approach—based exclusively on the objective mathematical properties of sine waves that precisely determine their behavior—would be employed instead of a predominantly empirical approach whose reliance on simple indicators (e.g. total number of stocks trading above their moving averages) and/or derived calculations (e.g. the incorporation of simple indicators into increasingly sophisticated algorithms) would prove considerably less accurate.

For example, a series of investment decisions based exclusively on the precise, empirical properties of the hypothetical stock market sine wave below would be executed as follows:

  • As a downward move is initiated at the top of the wave in early January, a new short sell transaction would be executed. And once at the bottom of the wave in late January, a short cover transaction would be executed in order to realize a trading profit.
  • Moments later, as an upward move is initiated at the bottom of the wave in early February, a new buy transaction would be executed. And once at the top of the wave in late February, a sell transaction would be executed in order to realize an additional trading profit.
  • The cycle then repeats itself as a series of alternating downtrend and uptrend profit-taking transactions.
Figure 1: Hypothetical sine wave behavior assumed by the market

This powerful example of purely empirical market timing demonstrates how an intricate understanding of a sine wave's behavior of symmetrically alternating highs and lows results in a series of compounding trading profits. In other words, all predominantly empirical indicators (e.g. derived calculations) and predominantly and/or purely emotional factors (e.g. fears of whether or not the pattern will randomly continue upwards after a sell transaction has been executed and the consequences of buying back in as the trend continues downwards) are excluded from each investment decision in order to more conservatively deliver profits.

Emotional Timing
Emotional timing approaches are far more prevalent given their lower reliance on empirical techniques. The two most common approaches include the traditional buy-and-hold approach that employs empirical inputs to varying degrees and the "I can't stand it anymore" (ICSIA) timing approach that minimizes or even excludes all empirical inputs. As demonstrated in Figure 2 below, a greater relative utilization of emotional techniques typically delivers lowered performance outcomes.

Although the leading emotional approach, a buy-and-hold timing strategy nevertheless represents a very elementary and inefficient form of market timing as investors willingly abandon multiple interim profit opportunities given the inherent fluctuation of the market. Investors simply hope to realize a profit over the long term while bypassing protracted periods of losses. The result: trading profits are directly limited to the extent to which an absolute uptrend (in the case of an initial buy decision) or downtrend (in the case of an initial short sell decision) has been captured i.e. timed.

The majority of investors unfortunately employ a far more destructive variant of buy-and-hold timing known as ICSIA timing. Rather than hoping to realize a profit over time, investment losses are incurred given investors' inability to suppress emotional reactions to market fluctuations and to incorporate any relevant empirical inputs. ICSIA induces many investors to finally jump into a market environment only after a long period of market gains and also prompts its followers to remain invested even as they begin to lose money until they cannot stand the losses any more. The result: losses are exaggerated when positions are exited at very depressed prices.

Empirical vs Emotional Timing
Unlike empirical approaches that aim to understand market behavior to varying degrees of detail, emotional timing approaches view the market as inherently unpredictable and as a result will always leave investors susceptible to market fluctuations. Consider a final example regarding the decision to sell: when stocks are down, investors don't know whether their losses will continue further and so selling seemingly represents the only rational way to minimize further losses. The corollary is also true: when stocks are up, investors don't know when the gains will end as every peak is preceded by a prior peak and thus selling seemingly represents an irrational way to prematurely miss future gains. By minimizing the unknown with a disciplined descriptive methodology, the most precise empirical approaches will always triumph over their emotional counterparts. Figure 2 below summarizes the relationship between the two analytical timing approaches, their return on investment and overall prevalence.
 
Figure 2: A comparison of empirical and emotional market timing approaches

Although the market is clearly incapable of assuming the hypothetical sine wave behavior described earlier, Marketpolygraph nevertheless delivers empirical research based solely on the observed fluctuations of the market. With Marketpolygraph, purely empirical market timing no longer represents a hypothetical investment approach: all other inputs, including all forms of derived empirical computations, are considered overly subjective in determining the direction of the market. As an index-centric objective framework of descriptive concepts, Metatechnical Theory is simply unprecedented.

 
 
A New Concept

"Almost every field of human activity has benefited from the adoption of the scientific method. Chemistry, physics, biotechnology and a myriad of other activities have made spectacular advances by the basic tools of observation, recording, classification, formulating a falsifiable hypothesis, testing that hypothesis, publishing the results for review by peers, and going back to the drawing board. Popular investment literature is the exception to this great trend; it is rife with guru-worship, superstition and mythology."
 
Victor Niederhoffer
DailySpeculations.com

 

"Humans are predictable in nature which lends to high probability trends and price action...Price action also tends to repeat itself because investors collectively gravitate toward patterned behavior."
 
Greg Troccoli
Forbes.com
August 17, 2011

 

"Growth of wealth can be had in this environment, but the price today is increased awareness of alternative styles and the experience to execute the strategy."
 
Robert Isbitts
Emerald Asset Advisors
PRNewswire.com
May 31, 2005

 

"Stocks aren't chaotic, and although it might seem like it, the Nasdaq didn't move from 5000 to 2000 in a day. The markets move as the seasons do, in observable and traceable trends. In short, there's a method to the madness."
 
Jonathan Hoenig
SmartMoney.com
August 9, 2001

 

"The theory was ... you can't make money in the market because it's unpredictable…over the past 10 to 15 years, there's been this huge amount of evidence coming in that's starting to suggest that the market is predictable one way or another."
 
Jeremy Stein
Professor of Economics
Harvard University
Harvard Gazette
November 2, 2000

 

"...the market is not completely random after all, that it has, so to speak, a memory."
 
Jim Holt
The Wall Street Journal
July 5, 1999

 

"Money is just a type of information, a pattern that, once digitized, becomes subject to persistent programmatic hacking by the mathematically skilled. As the information of money swishes around the planet, it leaves in its wake a history of its flow, and if any of that complex flow can be anticipated, then the hacker who cracks the pattern will become a rich hacker."
 
Kevin Kelly
Wired.com
July 1994
 
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