Timing the Market

People often glibly issue warnings against "timing the market" without thinking about the underlying assumptions. What is "timing the market"? It is usually taken to mean buying (selling) when you think a share is due for immediate appreciation/depreciation. However, we all buy (sell) only when we expect gains inside a time frame we consider acceptable. And time frames can be very flexible.

To a day-trader, "immediate" is the next 15 minutes. For a position-trader, it could mean within the same derivative settlement -that may be several weeks. For a medium-term investor, it is a deal that incurs short-term capital gains – that is, within the same year. For a long-term investor, it may mean a full business cycle– that could be several years.

The flexibility of time frames is partly personal convenience. You find it most convenient to oversee your investments on a weekly or monthly basis. So, you choose a month or week as your time frame.

But there is also a sound mathematical reason why investment time frames are flexible. Share prices are fractal. Like other fractal quantities, they fluctuate indistinguishably across different time frames.

The easiest way to understand this is to examine price trends across different time frames. Say you take printouts of 5-minute bars, daily bars, weekly bars and monthly bars. Now black out the price values and timestamps. It's impossible to say which time-series represents what periodicity. This is typical fractal behaviour. Another example is a map of a physical location such as a coastline. If you don't know the scale, the same map could represent a continental coastline or five metres of beach.

The fractal nature of share prices means that, if you pick the right direction, across your chosen time frame, you make money. It doesn't matter what time frame you choose; you must pick the right direction. That means, you have to "time the market", whatever your chosen time frame.

This is where investment philosophy breaks into several different schools. The "random walkers" say it doesn't matter what shares you pick, across what time frames. If the market is efficient, your return will be random. If you're lucky you will make lots of money and if you're unlucky, you'll lose a lot.

The value investors say that if you buy sound businesses cheap over long time frames, you beat the street. The technical analysts believe that if you study the specifics of price movements, and buy or sell when you can decode the trends, you beat the street.

All three schools boast spectacular successes. All three schools also boast spectacular failures. Any system which offers you personal comfort is more likely to work for you. There is another question where market philosophies differ. Let's say a stock is down across a given time frame but the underlying business isn't bankrupt. Should you buy or sell?

The random walkers would suggest tossing a coin – previous price should not influence future trends according to them. The value investors say buy. The business is sound; you're getting it cheap. The technical analysts say that you shouldn't buy until a trendreversal. In fact, you should sell to make profits on the downturn.

Both the value investment school and technical analysts have some logic on their side; both methods can work or fail. If the value-investor has misjudged the fundamentals, he loses. The technical analyst will, at the least, forego profits and he may lose heavily if he shorts at the wrong moment.

After all that philosophising, consider a specific case – the universe of Indian stocks, minus the 300 largest. Over the past year, this "sub-300" set has underperformed bigger stocks. Over the past three years, it has outperformed. And, this universe contains many sound businesses.

Pick the right ones and you're buying them cheap. Of course, they may lose some more ground so long as the current trend continues. But if you pick the right ones and then mix in a rough 2:1 ratio with bigger stocks, you're creating a low-risk portfolio with a decent upside. But it may take another three years or longer to generate good returns.

Can you do this and thus, time the market over a period of about three years? DSPML is betting that it can, by launching a new Micro Cap closed end fund which will aim to do precisely this. The Micro Cap Fund will turn open-ended three years later so that is the effective minimum time frame. I like the concept because just one ten-bagger will balance off several mediocre picks. And the sub-300 universe is a good place to look for ten-baggers.

DSPML Micro Cap Details:
Type of scheme: Close-ended equity scheme
NFO closes: May 25, 2007
Minimum investment: Rs 10,000
Cost per unit: Rs 10
Entry load: Nil during NFO
Exit load : 0%-4% (if held for more than 36 months or sold within 12 months of allotment)
Mandate: Stocks that are not part of the top 300 by market capitalisation will constitute 65%-100% of portfolio. Stocks in the top 300 will be allocated 0%-35% of portfolio.