How this buy-and-hold investor times the market
Reprinted courtesy of MarketWatch.com.
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After you choose the best possible asset classes for your portfolio, one big question remains: When do you get into the market, and when do you get out?
For most people, the best answer is to buy when you have money to invest and sell when you need money from your portfolio. This is known as buy-and-hold investing. When it’s properly implemented, this approach is elegantly simple.
But in real life, people tend to react emotionally to market ups and downs. As a result they often wait to buy until stock prices have been going up to the point that any “bargains” are long gone.
Likewise, buy-and-hold investors often wait to sell until prices have dropped so much that they just can’t stand the emotional pain of remaining in the market.
These moves are almost always counterproductive.
This pattern is often flamed by the financial media and Wall Street’s sales forces, which are always eager to generate trades.
The resulting phenomenon, known as the DALBAR effect, has been extensively documented for decades. Emotion-based buying and selling typically robs investors of much of the gains they could have achieved by buying and holding.
The good news is that there is a better way, at least for some investors. It’s known as mechanical market timing.
The bad news is that it doesn’t work for most investors.
Mechanical market timing, which I use for part of my own portfolio, is very different from the emotional in-and-out trading I just described.
Mechanical timing relies on rigid rules or “systems” designed to identify times when the market is more likely to go up than down, and times when it is more likely to go down than up.
This sounds like a form of prediction, but it isn’t. The systems I recommend are known as trend-following. That means they issue buy and sell signals that are based on actual market trends, both up and down.
When you design such a system, you want it to be able to ignore short, minor price trends that will turn out to be mere “noise” and yet react to price trends that, based on lots of history, have a relatively high probability of producing a profit or of avoiding major losses.
In the latter case, the hope is that you will sell an asset and be able to buy it back later at a lower price. (Below you will find a couple of simple examples using numbers.)
These resulting signals have nothing to do with any human predictions or feelings, nor anything to do with economic news or market forecasts.
These systems can be fine-tuned to issue many signals (a nervous, worrywart approach) or to issue signals only rarely (a don’t-bother-me-unless-it’s-really-big approach). The ones I use are in between those extremes.
How do trend-following timing systems help investors? The biggest thing they do (and they are essentially guaranteed to do it) is to reduce investment risk. They do this by prescribing certain times to be out of the market with your money in a money-market fund.
The guarantee is based on this fact: Whenever you aren’t invested in an asset, you can’t lose money if its price drops.
Some people think timing is supposed to boost returns, but that is a myth. A timing system cannot increase returns in a rising market; if you’re in, you’re in, period.
Mechanical timing systems are guaranteed to reduce investment risk. There are some other guarantees I can make about them, too.
For one thing, I guarantee that mechanical timing systems will drive many investors nuts. The systems aren’t designed to get investors out at the very top of a market cycle; their sell signals come only after a downward trend is strong enough (depending on the system’s rules) to suggest danger.
Nor do these systems issue buy signals until the market has already been going up strongly.
Another thing that drives timers nuts is “losing trades.” Here’s an example. You are timing an index that is falling, and the signal tells you to sell at a price of 125 (These numbers a illustrative and not based on actual trades). After you sell, the price drops to 115 and you feel good. Then the index starts going up, but your system doesn’t issue a buy signal until the price is 128.
If you follow the system the way you should, you will pay 128 for an asset you previously sold for 125. This is neither fun nor profitable.
Historically, you can expect that half or more of the trades generated by a typical timing system will be “losing.”
You may be wondering how all this is any help at all.
Timing shines by generating a relatively few large “winning” trades that make all the others worthwhile.
To continue the hypothetical example above, imagine you sold at 125, the index kept going down until it bottomed out at 95 and then it started upward again. If the system issued a buy signal at 105, you would get a bargain price to buy back the assets you previously sold for 125.
I once did a detailed study of a published timing system and how it performed when it was applied to four mutual funds over a multiyear period.
Over the whole period, timing performed better than buy-and-hold. But upon close analysis, it turned out that the improved performance was the result of only a handful of winning trades.
Dozens of other trades were “losing” ones that had to test investors’ faith repeatedly.
Because of these emotional challenges, most investors tend to second-guess the systems and fail to follow their signals. That dooms the systems to failure.
As I mentioned, I have half of my own portfolio governed by mechanical market timing, and I’ve been successful. But the only way I can succeed is to have somebody else do the computations and make the trades for me.
If I had to do all that myself, I would soon be an emotional wreck and would probably abandon the discipline.
Another reason timing works for me is that it governs only about half of my investments. The rest, I own on a buy-and-hold basis. I understand that in some years buy-and-hold will do better than timing, and vice versa.
Having some of each ensures that I’ll always have at least a big part of my portfolio in whichever approach is outperforming. I know other investors who use this same approach, and they report that this dual strategy gives them added peace of mind.
In my next article, I will show you some results of timing based on actual managed returns from 2000 through 2014.
Meanwhile, I suggest you check out my podcast, “The best market timing system I know.”
If you’re a serious student of market timing, you could learn a lot from Dennis Tilley, a man I consider the best timer in the industry assetclasstrading.com.
Richard Buck contributed to this article.