Timing Risk: What It is, How It Works, Performance

What Is Timing Risk?

Timing risk is the speculation that an investor enters into when trying to buy or sell a stock based on future price predictions. Timing risk explains the potential for missing out on beneficial movements in price due to an error in timing. This could cause harm to the value of an investor's portfolio resulting from purchasing too high or selling too low.

Understanding Timing Risk

There is some debate about the feasibility of timing. Some say that it's impossible to time the market consistently; others say that market timing is the key to above-average returns.

A prevailing thought on this subject is that it is better to have "time in the market" than trying to "time the market." The growth of financial markets over time supports this, as does the fact that many active managers fail to beat market averages after factoring in transaction costs.

For example, an investor is exposed to timing risk if he expects a market correction and decides to liquidate his entire portfolio in the hope of repurchasing the stocks back at a lower price. The investor risks the chance of the stocks increasing before he buys back in.

Timing Risk and Performance

A study analyzing investor behavior found that, during the October 2014 downturn, one in five investors reduced exposure to stocks, exchange-traded funds (ETFs), and mutual funds, and roughly 1% of investors reduced their portfolios by 90% or more.

The investors who sold 90% of their holdings realized a trailing 12-month return of -19.3% in August 2015. Investors who took little or no action returned -3.7% over the same period. This example shows that market timing may fail as a money-making tool.

Special Considerations

Higher Trading Expenses

Investors who are continually trying to time the market are buying and selling more frequently, which increases their fees and commission charges. If an investor makes a bad market timing call, additional trading expenses compound poor returns.

Additional Tax Expenses

Each time a stock is bought or sold, a taxable event occurs. If an investor is holding a profitable position in a stock and sells it with the intention of buying in again at a lower price, he must treat the capital gain as regular income if the two transactions occurred within a 12-month period. If the investor holds the position for over 12 months, he gets taxed at a lower capital gains tax rate.