Copywritten by Equitrend, Inc. in 2006.
No matter what type of investing you do, there are three important ways to measure your success: the drawdown from peak to valley, the beta, and the reward/risk ratio. Your level of risk is the first and most important thing to think about. Performance volatility is a way to measure how different the rate of return on an investment can be.
In particular, it is the standard deviation of the sample set of monthly returns on the investment that have been seen over the time period being looked at. A simple way to tell if a stock market timing system is good is to figure out the biggest drop from peak to valley in the last five years. This drop in value is how you measure risk.
Second, compare your beta to the market as a whole. Beta is an important variable that lets you compare the volatility of a portfolio or timing system to that of an index. The S&P 500 index is used to figure out most Betas. A beta of one means that the system is as risky as the S&P 500 index in terms of its volatility. If the system has a beta of 2, that means it is twice as volatile as the S&P 500 index.
By actively managing your money, your stock market timing system should let you lower the beta of your portfolio compared to the index you are trading and significantly improve your returns over time.
Third, there's your reward-to-risk ratio, which tells you how much money you'll make compared to how much you'll lose. You need to know your average rate of return to figure this out. A good rule of thumb is that your return should be at least twice as big as your risk. For instance, if your biggest drawdown from peak to valley over the last five years was 15%, your average rate of return should be at least 30%. In other words, your risk-to-reward ratio (30% - 15% = 2) should be 2 or higher.
Your personality, especially how willing you are to take risks, will have a lot to do with the best stock market timing system for you. You might think that a trend-timing system that works on average 80% of the time is great, but what if I told you that system had a risk potential of 35%?
Most people can't stand a system that takes more than 20% of their investment capital. You should be able to find a stock market timing system that works for you based on how you feel about risk and how willing you are to take it.
Only a few of the systems out there really work. Most are like mayflies on a hot summer day: they come and go. When judging a timing system, it's important to think about all of the things listed above, as well as how well the system has worked for at least five years. If they've worked for the last five to six years, you may have found a good way to time the stock market.
