The secret to making money in financial markets is straightforward enough. Just buy when prices are low, and sell when they're high.
Trouble is, it's not easy to do. Attempting to purchase securities when prices are lowest and selling when they're highest sounds simple enough, but there's a lot of knowledge and research that goes into properly timing the markets. Even professional money managers often have difficulty achieving this ideal. That's because nobody can really predict when stocks have hit their lows or highs until after the fact.
Trying to move in and out of the market at its valleys and peaks is known in investment circles as "market timing." And while it can make the few who are successful wealthy (which often has as much to do with luck, not skill), for most of us it has more pitfalls than potential.
Changing your investment focus at the wrong time can be a costly move. Studies have shown that smaller investors tend to jump in and out of investments at the wrong time. When an asset class - say, stocks - is on a downturn, they tend to wait until the worst is over before making an exit, only to miss out on rebounding prices later. Then, when they move back into these securities, they're forced to pay inflated prices.
This tendency applies both to direct investors and those who invest through mutual funds. By switching in and out of funds in an attempt to time the market, the same problems arise. In fact, trying to time the market runs contrary to one of the best reasons for investing in mutual funds - to benefit from the expertise of professional money managers. It's better to leave the investment decisions to the pros.
So what's the alternative to market timing? Try a buy-and-hold strategy - invest for the long term and ignore short-term market fluctuations.
The best way to do this is through asset allocation - spreading your investment across different types of assets. The three major asset classes are: cash (such as money in the bank and short-term investments), fixed-income assets (such as Guaranteed Investment Certificates) and equity-based assets (such as stocks or shares of businesses and corporations). Asset allocation has many advantages - as you gain exposure to different investment types (saving, income and growth), you reduce your potential investment risk.
Asset allocation can also be used to adjust investments to suit your changing needs. For instance, a younger investor may take a more aggressive, growth-oriented approach, while in later years, the same investor may choose more conservative investments. (Asset allocation will be discussed in detail next week.)
If you invest in individual securities, there may be times when there are good reasons to buy or sell individual securities - for example, when you're happy with the profit you've made on a stock or if changing company fundamentals are endangering its share price. But that's much different from trying to time the market by selling all your equity holdings because of market conditions.
I will show you how a steady, long-term approach can help you avoid the pitfalls of market timing.