Finance The temptation of market timing It’s easy to see the temptation of market timing. Most markets (and many asset classes) are fundamentally cyclical in nature: they move up, then they move down, then the cycle repeats. The idea that a smart, attentive investor can predict just when such cycles will begin and end (and perhaps more importantly, when they will “turn”) is pretty compelling. Indeed, many financial professionals spend their entire day (and their entire careers) looking at cyclical “signals” – financial and economic indicators that reflect what phase of the market cycle we happen to be in at any given moment. These indicators could be based on any number of economic data: the strength of a country’s exports, for example. Or whether corporate purchase managers are buying raw materials and equipment. Or the prevalence of margin investing. Or whether wages are growing in the economy. Or a variety of other factors. Learn to interpret these indicators correctly, and you’ll get a clue about what the economy is doing. If you can figure that out, you can probably figure out whether the market is poised for further gains, or is about to take a tumble. At least, that’s the theory. Fundamental to any market timing strategy is predicting the future – or at least, making an educated guess about it. And that’s the problem. Just because you understand how a given piece of data might affect the overall market, doesn’t mean that you can accurately and consistently predict if it will happen, much less exactly when you should enter or exit a given position. Still, you don’t need to make a career out of market timing for it to pay off handsomely. All it takes is one correct prediction – getting in early on the “next big thing” or sidestepping a market meltdown which no one else saw coming. This is the ultimate temptation of timing: you only have to do it once to make it worthwhile. Examining the evidence: does market timing actually work? So – does market timing actually work? Over the years, there have been many academic studies that have tried to quantify what advantage (if any) there is to market timing strategies. Some of the most persuasive of those studies have attempted to demonstrate how incredibly difficult timing is in the real world. To illustrate this difficulty, the studies compare the performance of the broader equity market over a given time period to returns of a typical “market timer” who pulls money out of the market for a certain number of days during the time period. One study by U.S. brokerage firm Charles Schwab examined the return of the Standard & Poors 500 Index (a good stand-in for the performance of the U.S. equity market as a whole) between the years 1996 and 2011. The study then compared those base returns to returns which a market timer would have actually experienced if they had missed 10, 20, 30 or 40 of the best performance days in the market over the 15-year time period. The findings were startling: if investors had missed the top-10 performing days during that time period (remember, this is a mere 10 days out of a total of 5,475), investor returns would be cut almost in half. And, as the chart shows, the more days missed, the more returns the investor gave up. Ultimately, this is the main reason why market timing is so easy to talk about, yet so difficult to put into practice. -4% -2% 0% 2% 4% 6% 8% 10% Miss 10 best days S&P 500 Index 7.8% 4.1% 1.7% -0.4% -2.3% Miss 20 best days Miss 30 best days Miss 40 best days S&P 500 Index performance 1996 - 2011 Source: SchwabCenter for Financial Research As any investor knows, the stock market rarely moves up or down in a slow, steady line. More often it moves quickly, suddenly and unpredictably. When the bulk of your returns are concentrated in a very short time frame, the consequence of getting your timing decisions wrong can be quite severe. Keep inmind that many of those top-performing days (not all, but many) occur after a significant downturn – typically the time at which market timers have exited the market, waiting for sentiment to improve and market losses to turn to market gains. 34 | www.snowbirds.org
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