Buy low, and sell high. Rinse and repeat. Just like stock picking, it’s so easy a caveman could do it.
Market timing seems rather simple at surface level. Just figure out how to determine when stocks or bonds or any asset is priced improperly, and then figure out when exactly things will return to “proper” pricing. With these two pieces of information, an investor can easily hop in and out of various asset classes while making huge sums of money.
Sound great, right? But is market timing a viable investment strategy?
Empirical evidence suggests not. If at all possible, the likelihood of sustained success is slim.
What is Market Timing?
When most people talk about market timing, they are referring to the stock market. The other common asset classes, like bonds and cash, are often a part of market timing strategies, but they are secondary to stocks. This is because stocks fluctuate in value much more frequently and rapidly than the other asset classes, and therefore present the greatest opportunity for gains in the event of successful market timing.
So for this article, we’ll define market timing as any attempt to alter a portfolio’s asset allocation in response to short-term stock market developments. Some common examples:
Rotating asset classes — Perhaps the best example of market timing which involves shifting between stocks, bonds, cash, etc. in anticipation of future performance. Examples include holding more cash/bonds in anticipation of a stock market decline, or holding 100% equities when expecting a bull stock market.
Rotating equity styles — Examples include shifting from growth to value investing in anticipation of a market decline, or from foreign to domestic equities in anticipation of bad foreign markets.
Rotating equity sectors — Examples include shifting between technology stocks and energy stocks in an attempt to be more “defensive.” Or, over-weighting a portfolio with health care stocks because you think that sector will outpace the economy on the whole.
Picking individual securities — Stock picking is often part of the strategies listed above.
There are countless other examples.
Is it Really That Difficult?
Professor and Nobel Laureate William Sharpe wanted to identify the percentage of time a market timer would need to be correct to break even relative to a benchmark (index) portfolio. He concluded a market timer must be correct 74% of the time to outperform a passive portfolio at a comparable level of risk. (1)
Subsequent studies have concluded that market timers need to be correct between 70-85% of the time to outperform a comparable passive portfolio, validating Sharpe’s work.
And why is this the case?
Successful market timing requires two components – being in at the right time, and out at the right time. If you miss either move, you’ll under-perform a simple buy and hold strategy. This is what makes market timing nearly impossible.
Consider the following scenario. If the stock market has been on a five year upward march (much like now?), you might conclude that it’s “overvalued” based on some valuation scheme or historical indicator. So you sell most of your stock holdings and move to an alternative liquid investment like cash or short term bonds in anticipation of a stock market correction. The problem is that you’ll miss all the gains produced until that correction. Is there any reason the market can’t continue the upward climb for another few years? I think not.
Even if you get lucky and exit near the peak, you’ll have figure out when to buy after the market corrects. How do you know how big the correction will be? Should you buy when it falls 5%? 10%? How about 20%? There is no way to tell. And there are a couple of dangers here: The market could continue falling even after you buy back in, or you could wait too long and miss the upswing. Most big corrections are quickly followed by big rebounds, and it’s impossible to know when the market has hit rock bottom.
These problems are exacerbated by the fact that a very small number of days account for the bulk of stock market returns.
An investor in the S&P 500 index would have earned an annualized return of 9.22% throughout the 20-year period ending on 12/31/2013, growing a $10,000 investment to $58,352. When the five best-performing days in that time period were missed, the annualized return shrank to 7.00%, with $10,000 growing to $38,710, and if an investor missed the 20 days with the largest gains, the returns were cut down to just 3.02%. If the 40 best performing days were missed, the investor would have lost $1,851, with his $10,000 initial investment eroding in value to just $8,149!
As Professor Estrada summarizes in “Black Swans and Market Timing: How Not To Generate Alpha” (2):
The evidence, based on more than 160,000 daily returns from 15 international equity markets, is clear: Outliers have a massive impact on long-term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent, in the average market, less than 0.1% of the days considered, the odds against successful market timing are staggering.
Black swans render market timing a goose chase. Attempting to predict the negligible proportion of days that determines an enormous creation or destruction of wealth seems to be a losing proposition. Of the countless strategies that academics and practitioners have devised to generate alpha, market timing seems to be one very unlikely to succeed. Much like going to Vegas, market timing may be an entertaining pastime, but not a good way to make money.
University of Michigan Professor H. Nejat Seyhun shares similar findings (3):
Between 1926 and 1993, more than 99% of the total dollar returns were “earned” during only 5.9% of the months. For the 31-year period from 1963 to 1993, 90 trading days accounted for 95% of the market gains.