Over 100 years ago, Charles Dow devised a theory on how financial markets work. He found that markets tended to move in cyclical trends. Instead of forecasting the future moves of individual stocks, the original focus of Mr. Dow was the determination of the current market trend.
In broad terms we now refer to these trends as bull or bear markets. And it was after establishing whether a bull or bear market was in effect … Mr. Dow would trade with the trend.
So how does Mr. Dow’s Theory of trends help us beat the market today?
First let’s narrow down on what is … “the Market.” The Market is often used in the same breath as the Dow Jones Industrial Average or the S&P 500. And in this sense, it’s a group of stocks tracked as an index. The index allows the investor or trader to make inferences on all publicly traded stocks … a group of stocks … or even a single stock.
With the exception of more exotic strategies … the conventional wisdom for beating the market—held by most investors—suggests you need to own stocks that rise further in bull markets but fall less in bear markets .
But sadly, it is very difficult to find “one stock” or single investment position that will do both.
In the case of small cap stocks … they can go up and down significantly with volatility. The defensive stocks that held up during the bear market will now underperform during the succeeding bull market.
So again … how does an investor beat the market if he can’t get both at the same time? This is where Mr. Dow comes back into play.
The Dow Theory of Rocket Stocks
When a bull market ends and a bear market begins … and if trends persist for a prolonged period of time … then it is in the investor’s best interest to liquidate the bullish position once the beginning of a new bear market is identified. And staying sidelined until a new bull market is confirmed is part of the key to successfully timing potential profits.
Investors often get tunnel vision and spend more time on trying to find the the next hot stock. I would argue that spending more time on determining the current market cycle … will lead to greater potentials for profit … in any market.
To illustrate this more clearly, let’s compare Mr. Amazing Stockpicker, who does not use market timing, with Mr. Timer … an investor who uses market timing but simply trades the S&P 500 index.
This first chart tracks the portfolio (red line) of Mr. Amazing Stockpicker’s consistently winning picks year over year. While he beats the market (blue line) over the past 11 years, it was not without significant volatility—or increased risk—when the bear market hit.
Contrast this with the second chart of Mr. Timer, who has a totally different approach. Both the red and blue lines represent the S&P 500 and any excess gains earned from timing the market.
During the long bull market cycle, the two portfolios rise proportionately. And while the final gains in the second chart are similar to the first … Mr. Timer’s gains are achieves with significantly lower risk.
And Mr. Timer didn’t have to rely on any exceptional stock picking capability!
The Advantage of Market Timing on Rocket Stocks
The advantages of this type of market timing are obvious. First, we don’t need to find superior stocks that rise strongly in bull trends in order to beat the market. We can hold average stocks or even a broad market index.
If we do decide to invest in volatile stocks, we no longer need to be exposed to the full consequences of downside volatility during a bear market. If you take the time to determine when the bull or bear market begins, you will have discovered the secret to beating the market with virtually any stock in your portfolio.
Of course I would encourage you to learn about stock selection strategy in order to compound your gains. But the added benefit of market timing alone can’t be overlooked. And the potential for maximizing profits is substantial.
Just consider one such model at the Portfolio Café. This model targets smaller, high-quality stocks during bull markets (Small-Caps Under $15):
Historically this model has yielded 60% returns with less downside exposure than the broader market.
Even with the above evidence … you may still have questions about market timing as an effective tool. Questions like … what proof is there that this practice is possible? … What are the methods of timing the market, and which are the most successful? … or … What are the criticisms of using such an approach?
Stay tuned to Portfolio Café to not only get your questions answered, but also to learn how to invest like your own hedge fund … with market beating gains and far less risk.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer