Why Market Timing Doesn’t Work
Reprinted courtesy of MarketWatch.com.
To read the original article click here
When the federal government can be turned on and off as if activated by a light switch, the stock market understandably flips and flops unpredictably. Investors wonder what they should do.
Wouldn’t it be nice to have a timing system that capitalizes on the upside and avoids most of the downside damage?
Maybe; but maybe not.
First, I know a lot about market timing, which I’ve been using and teaching for 30 years. Second, in theory market timing is brilliant. Third, in practice it just doesn’t work successfully for most investors.
I want to start by making it clear that I know what I’m talking about. The investment management firm I started (with which I am no longer affiliated except as a client) has been using market timing since it opened its doors in 1983.
For 20 years, I led investor workshops on market timing. In 1985 I wrote a book on the topic (now out of print). I have met more than 100 professional market-timing professionals and, like most of them, I have personally evaluated hundreds of timing systems. In 1995, our firm started a hedge fund, still in operation, that combines asset allocation, timing and leverage.
As I wrote last week, about half of my own investment portfolio is governed by timing.
Still, I don’t think more than perhaps one in 100 investors will be successful using timing.
To understand why, lets recap the basic theory of the sort of market timing in which I believe. It’s a strict discipline that uses mechanical trend-following systems, as I described in my previous column on timing.
Mechanical timing doesn’t rely on predictions, which are only opinions. They rely on documented trends, which are facts. This means a “sell” signal doesn’t result from somebody’s fear or belief that the market is about to take a nose dive. Instead, such a signal results from actual price declines that the system regards as strong enough to be likely to continue. Buying signals on the upside work similarly.
When a timing system correctly identifies the beginning of a strong downward trend, it allows the investor to move to cash and avoid the major damage from a bear market. This inevitably reduces the investor’s risk, because every day you are in cash you aren’t exposed to the risk of market loss.
So, in theory at least, timing is a fail-safe way to reduce stock-market risk.
But that’s a little bit like saying “In theory, you’re guaranteed to get from Point A to Point B if I strap you onto the back of a starving bucking bronco that’s hellbent on getting to food.” You may get there, but you wouldn’t like the journey.
Investors don’t like losing money. Yet you’ll do just that about half the time when you follow a trend-following timing system.
Investors especially don’t like losing money time after time. But you’ll often have multiple losing trades in succession before timing produces a profit.
Investors hate to be wrong and have it rubbed in their faces. But often a timing system can tell you to sell a fund at a certain price and then buy it back at a higher price. Even though this is normal, it makes timing seem insane — producing losses instead of preventing them.
Investors hate to make mistake after mistake. Yet a timing discipline requires them to keep buying and selling without knowing the outcome. The moment you override the system, there is no system left and the strategy has failed. You have no way to know when to jump on the bandwagon again except by following your emotions — and that is a notoriously poor way to time your investments.
Investors want everything they can get during bull markets. Yet the very nature of trend-following timing systems virtually guarantees lower returns during those good times.
Investors — at least those who are counting on timing to protect them — don’t like to sit idly and lose money while they wait for their system to recognize “what any idiot can see,” that the market is heading down.
Investors like what they are doing to “make sense.” Most of the trading signals generated by trend-following systems fail that test.
I could go on, but you get the point.
Fortunately, there are ways to overcome some of these problems. I’ll give you five examples.
First and perhaps most important is to maintain reasonable expectations. Don’t expect miracles. Despite the sales pitches from professional timers, timing isn’t a way to beat the market. That should not be your objective. A much more realistic goal for timing is to protect your investments from big market declines.
Second, don’t try to do it yourself unless you are certain you can carry out an ironclad discipline through thick and thin. I promise you this: Timing’s short-term results are certain to disappoint you from time to time. Hire a professional to make the trades for you using strictly mechanical trend-following systems. You’ll find plenty of timers online, but some of them charge too much. I don’t think you should pay more than 1.5% for timing.
Third, don’t neglect proper asset allocation and diversification. My timed portfolio holds the same asset classes as my buy-and-hold portfolio. Don’t invest in gold or other commodity funds, and don’t put more than 10% of your portfolio into any single fund.
Fourth, timing should not be your only defensive strategy. Your portfolio should include bond funds too. Together, these approaches can keep losses relatively manageable. The year 2008 was awful for many investors, with the Standard & Poor’s 500 Index SPX -0.49% falling 37%. My timing portfolio, 70% in equities and 30% in bonds, suffered a loss of only 10.7% that year.
Many market timers don’t agree, but the long-term pretax returns of market timing and buying and holding are often very similar. Therefore, my last suggestion:
Fifth, consider managing half your portfolio with timing and half without it. (More on this next week.) That’s what I do, and it gives me a lot of peace of mind.
Or … just skip the whole timing thing. Nearly half a century of working with investors has taught me this: Many people who try buy and hold succeed, while most of those who try timing (particularly those who do it themselves) fail.
Richard Buck contributed to this article.