Market Timing Basics

• Basic investing technique says you should buy shares of stock or mutual funds while they are at a low price, and sell them at a high price, making a profit on your investment. Market timing is the practice of doing this aggressively -- buying and selling shares within days or weeks of purchase. Traders use research, trends and instincts to determine which stocks are priced too low or set to gain value quickly. They buy the stock low, and sell when the price rises. The disadvantage of frequent trading is the cost: each trade comes with a per-share fee that lowers the profit of any trade. Buy-and-hold investors allow their stock to grow over a long period of time and plan that the growth of the stock will be significantly more than the one-time cost of selling the shares. Market timers and day traders work on a smaller scale, taking smaller profits more often to build wealth faster.
  
  

Trading in Mutual Funds

• Mutual funds are pools of investor money that is used to buy a wide variety of stocks or bonds. The value of a mutual fund is determined by the value of the investments it owns, and is calculated once per day at the close of the stock market. This is known as a Net Asset Value, or NAV price. Market timers take advantage of this by using the activity of mutual fund holdings to predict the NAV price and buying or selling accordingly. Most mutual funds, however, are designed around the buy-and-hold philosophy, minimizing trading of fund assets to minimize fees and operating costs for investors. When groups of individual investors practice frequent trading of fund shares, fund managers have to increase the number of trades of fund assets, driving up the cost of the fund and lowering performance.
  
  

The 2003 Mutual Fund Scandal

• In 2003, investigators discovered that some mutual fund companies were allowing preferred investor groups to practice short term trading. In some cases, short-term trading was forbidden by fund rules and therefore illegal. In many cases, the amount of frequent trading was great enough to cause harm to the fund's regular investors. This led to increased oversight of mutual fund companies by the Securities and Exchange Commission, along with regulations that allowed mutual fund companies to charge up to a 2 percent fee for shares sold within seven days of purchase.
  
  

Additional Rules

• Most mutual fund companies now charge fees for shares that are sold shortly after purchase, with the exact terms of the fee and time period set by each fund. In many cases, fund companies explicitly forbid market timing activities, including frequent trading. Investors who engage in timing practices have their trading ability restricted and may be banned from a fund. Fund frequent trading policies are outlined in the fund prospectus.