Why would someone attempt to time the stock market on when to invest and when to be safe on the sidelines (in a money market fund)? Reworded in a more friendly manner, why do investors use asset allocation (aka market timing) in their portfolios? The reason is that in the stock market there are only two types of risk.
The first risk is systemic that impacts nearly all stocks and industries, like recession. Systemic means inherent to the whole.
The second risk is specific to a company or industry. Think specific news that might impact that industry or specific company like news from the FDA or company capital structure changes. This risk is unique or specific to the stock or industry.
Systemic risk cannot be diversified away. When the market is rallying, nearly all stocks and industries will be rallying. It is the same to the downside. If the market is in a bear market, nearly all stocks and industries decline.
Specific risk may be diversified away by using broadly based mutual funds or ETFs, rather than company or industry specific funds. The S&P 500, for example, is broadly diversified with only systemic risk, but a technology fund adds industry or even company specific risk on top of systemic risk. Even with diversification tools, whether broadly or narrowly based that reduce specific risk, systemic risk always remains, if you are still invested.
To reduce systemic risk, passive asset allocation is the favored approach that uses diversification into other investment pools, like bonds. But the part invested in the stock market remains under systemic risk. Risk has not been reduced per se, only minimized from that part of the portfolio.
Active asset allocation, which is our approach, recognizes that the primary risk to investing, whether in a broadly based fund or in an industry fund or whether with 10% or 100% of your portfolio in stocks, is the systemic risk.
Which direction is the stock market moving? If the answer is upwards, then we use either the funds that have reduced specific risks to near zero (broadly based) or the funds, like technology or other sectors, that retain specific risk. In either case, systemic risk remains and that’s where our main market timing model we call ATM comes into play.
ATM is designed to capture the bull market moves upward and avoid the bear market moves downward. See our Newsletters for more details.