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How market timing reduces volatility

Reprinted courtesy of MarketWatch.com.

To read the original article click here

Many investors regard market timing as an attempt to make more money on investments. Occasionally that happens, as we shall see.

But that’s not the point of timing. Timing’s real purpose is to reduce investment risk, and you can count on timing to do that.

(Why am I so confident of this? Simple: Market-timing systems get you out of the market and into money-market funds from time to time; every day you aren’t invested is a day when you don’t face the risk of loss.) 

If timing won’t make you more money, why do it? If you’re timing an investment, you should realistically expect that your losses will be lower during the worst of times and your gains will be lower in the best of times.

That’s theory. What about the facts?

To evaluate how market timing has performed in the 21st century, I decided to find out how a well-diversified all-equity portfolio performed in the 10 calendar years 2005 through 2014 – with and without market timing.

I found that, as expected, timing substantially reduced the risk, measured by standard deviation, of this portfolio, decreasing the standard deviation from 18.3% (buy-and-hold) to 11.2% (timing).

Also as expected, timing substantially reduced the worst-year loss from 41.7% (buy and hold) to 18.3% (timing). Also, according to the standard playbook, timing’s best year had a lower gain (32.1%) than that of buy-and-hold (36.3%).

These results, which represent actual performance after expenses and fees, came from the investment advisory firm for which I used to work (and with which I have no further affiliation except as a client).

TABLE 1: Results of All-Equity Portfolios, 2005-2014

merrimantable1

As you can see, there’s a third line in that table: “Combination.” It shows the results of my preferred approach, which is to diversify further by having half a portfolio governed by timing and the other half invested without timing.

This golden combination gives me added peace of mind. I know that in many years, buy-and-hold will outperform timing; and in other years, timing will outperform.

Even though there’s no way to know in advance which approach will do better, by having half my money in timing and half without it, I know that I’ll always get the benefit of whichever one is doing better.

As you can see in the bottom line of that table, this combination slightly outperformed both buy-and-hold and timing during the most recent 10 calendar years. As you would expect, its best-year and worst-year performance was in the middle between these two components. Ditto for the standard deviation.

These results tell me that the combination delivered additional peace of mind with no reduction of performance at all.

To my way of thinking, that’s a win-win result!

Of course, market timing isn’t the only way to reduce investment risk. It isn’t even the best way.

The best way, at least in my view, is to own bond funds as well as equity funds. As I pointed out elsewhere, if stocks are the engine that moves your portfolio forward, bonds are the brakes that help keep things safe and sane.

For many retired investors who are concerned about risk, I believe a 50/50 mix of stock funds and bond funds is a good answer. The performance won’t be so robust, but the losses will be much less dramatic. This is similar to the mix I have in 90% of my own portfolio.

As you might guess, it’s just as easy to apply market timing to bonds as well as to stocks.

Accordingly, I wanted to know how such a 50/50 balanced portfolio held up in 2005 through 2014, with and without timing. The bond component is a combination of TIPS and short-term and intermediate-term government bond.

As it turned out, the 10-year compound returns on a 50/50 portfolio were nearly identical: 5.7% without timing, 5.6% with timing.

As you can see in Table 2 below, when half the portfolio was timed and the other half wasn’t, the resulting compound return was 5.7%, the same as that of the buy-and-hold component. And this combination — half stocks, half bonds, half with timing, half without, had lower volatility and a lower worst-year loss than buy-and-hold.

As a bonus, in its best year, the timed version was up 22.1%, vs. a best performance of 17.7% for the buy-and-hold balanced portfolio.

Again, this combination reduced risk without any penalty in 10-year return.

 

table-1For reference, in this same period the Standard & Poor’s 500 Index SPX, -0.95% compounded at 7.7% with a standard deviation of 14.7%; the EAFE international stock index compounded at 4.4% with a standard deviation of 18.2%; the Barclays Aggregate Bond Index compounded at 4.7% with a standard deviation of 3.2%; and U.S. Treasury bills compounded at 1.4% with a standard deviation of just 0.5%.

These numbers represent only a single 10-year period — and they’ll never be duplicated exactly again.

But they provide statistical evidence of the benefits that are possible when you adopt market-timing and when you split your portfolio 50/50 between timing and buy-and-hold.

Two important points should not be overlooked:

First, timing is an emotionally difficult way to manage a portfolio. Before you embark on it, be sure to read my market-timing article and inform yourself of the challenges.

Second, if you do commit to timing, don’t manage it yourself. Do what I do: Hire a professional to do it.

If you get past those hurdles, I can promise that timing will reduce the volatility of your portfolio. And I’m quite sure there will be periods when you’ll be glad you had at least some of your money governed by timing.

For more on this topic, check my podcast, “10 things you should know about bear markets.”

Richard Buck contributed to this article.