The basis
for timing the stock market and mutual fund
switching derives from the fact that ideally one
should be invested in the stock market when
prices are rising and out of (or short) the stock
market when prices are falling. This is easier
said than done and most mutual fund and brokerage
houses will tell you it cannot be done
successfully. However, contrary to what many
would have you believe, there are those who ARE
SUCCESSFULLY "timing" the market and it
is prudent for disciplined investors to follow
the advice of these market gurus.
There are two advantages to timing
the market. First, returns can be substantially
increased by only being in the market when it is
rising and out of (or short) the market when it
is falling. Second, you are in a much safer
position by being out of the market during
potential market declines because one never knows
how far a decline might take us. Recent history
tells us that the market always recovers from
declines and eventually makes new highs. However,
a longer look at historical price movements warns
us that at any time a perilous market decline
could happen wiping out as much as 80% of market
assets. It could be in the form of a market crash
or, more likely, it could be a slower oscillating
decline taking many years.
The Japanese stock market, one of
the hottest markets in the 80's, recently
reminded us of the perils of the "buy and
hold" strategy. The Japanese market peaked
at the end of 1989 and fell a whopping 67%
through the late 1990's. Nearly a nine year bear
market! Be aware that the US stock market is not
immune to a similar fate given the right
circumstances.
On the other side of the coin, there
are also some disadvantages to timing the market.
First, unless you are timing the market in a tax
deferred vehicle such as an IRA, your gains will
be taxable in each year that you take profits and
move out of the market. A buy and hold approach
will defer taxes on gains until you sell your
stock (however, mutual funds may pass profits and
losses to share holders for tax purposes even if
you don't buy and sell). Second, you or your
timing advisor might guess wrong about the market
direction and cause you to miss a large advance
by being out of the market or maybe not get you
out in time to avoid a large decline. And, third,
you might be on vacation when you should be
exiting the stock market! All of these
disadvantages can be satisfactorily addressed
with a little research and planning.
OK, so now that we know about the
advantages and the disadvantages of timing the
market, how do we go about doing it? Although
there are several methods available to time the
stock market, we are only going to address the
use of mutual fund switching within a single
family of funds. This method has several
advantages. First, we can use a no-load fund
family and avoid paying commissions when we wish
to move into or out of the market. Second, the
investment vehicles used to be "in the
market", "out of the market" or
"short the market" are available from
many no-load mutual fund groups.
To keep our discussion brief, lets
only discuss the Rydex family of mutual funds.
Rydex has three investment vehicles that are
ideally suited to timing the stock market. They
have a fund called the Nova Fund that attempts to
move exactly in proportion to the Standard &
Poors 500 Index. The ratio the Nova Fund tries to
move in relation to the index is 1.5 to 1 (also
called a beta of 1.5). That means if the S&P
500 Index rises 1%, the Nova Fund would probably
RISE 1.5%. And, if the S&P 500 Index falls by
1%, the Nova Fund would likely FALL by 1.5%. So
we can use the Nova Fund as our "in the
market" vehicle.
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The Rydex
family also has a money market fund where we
could move our money to the safety of an interest
bearing non-price-fluctuating account similar to
a savings account. For those not wishing to be
"short" the market when it is falling
this is the investment vehicle of choice during
market declines. We will use the Money Market
Fund as the "out of the market"
vehicle.
The third fund at the Rydex family
we could use would be the Ursa Fund. The Ursa
Fund is a new breed of mutual fund that moves
inverse to the stock market. What this fund
attempts to do is move up when the market is
falling and move down when the market is rising.
It accomplishes this by using short sales of
stock and market derivative products to earn
money for the fund during market price declines.
You don't need to understand the mechanics of
this because the fund manager takes care of all
that for you. The ratio that the Ursa fund tries
to maintain is 1 to 1. This means that if the
S&P 500 declines 1%, the Ursa fund will RISE
by about 1%. And if the S&P 500 rises by 1%,
the Ursa fund will FALL by about 1%. We will use
the Ursa Fund as the "short the market"
vehicle (except in retirement plans where short
positions are not allowed).
Now let's step through an example of
how this all works using some round numbers
and fictitious dates to make it easy to
understand.
Let's purchase $100,000 of the Rydex
Money Market Fund to start our investment on
December 1, 2009. Rydex sends us a confirmation
of our purchase and gives us an 800 number to
call and/or an on-line site to make exchanges to
other funds in the Rydex family of funds. Our
money is earning money market interest while we
wait for the next buy or sell signal from our
timing advisor.
Suppose that at the close of trading
on December 31, 2009 our advisor issues a
"BUY" signal. We then call the trading
desk at Rydex on the next trading day, January 2,
2010, and instruct them to move $100,000 from the
Money Market Fund to the Nova Fund. The S&P
500 Index on that date is 1000 and 10,000 shares
of our fund are purchased at $10.00.
Four months later, on April 30,
2010, our timing advisor issues a
"SELL" signal. We again call the Rydex
trading desk on the next trading day, sell our
Nova fund and purchase the Ursa Fund with 100% of
the proceeds. The S&P Index has risen to
1500, the Nova fund is sold at $17.50 (1.5 to 1
ratio) and we purchase the Ursa fund at $10.00.
We can now purchase 17,500 shares of the Ursa
Fund because of the profits we have made so far
in the Nova Fund. (Those not wanting to short the
market would purchase the Money Market Fund
instead of the Ursa Fund.)
Over the next eight months the
S&P 500 Index works it way down and finishes
the year at 1100. Our Ursa fund rose as the
market fell and finished the year at $12.66 (a
26% decline in the S&P 500 translated into a
26% gain in the Ursa fund).
Now lets make a table and compare
our results with that of a buy/hold approach.
Let's assume for the buy/hold comparison that we
bought the Nova Fund on January 2nd and held it
for the entire year.
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