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Busting Investment Myths: #2 – You Can Time the Market

By December 9, 2013 One Comment

When it comes to market timing – predicting the direction of the market and moving in or out of cash in advance to improve returns – there are two kinds of investors: those who don’t know where the market is going, and those who don’t know that they don’t know.

The well-groomed and articulate talking heads you see on TV or prognosticating in the financial press, like everybody else, have no idea where the market is headed, but their livelihood depends on upon them appearing to know. A recurring theme of almost all studies of “expert” opinion finds that it under performs the market about three-quarters of the time.

But let’s say you’re different and you’ve got an uncanny ability to call the market’s direction.

The following questions are repurposed versions of those posed in Robert Hagin’s excellent book Investment Management, Portfolio Diversification, Risk, and Timing – Fact and Fiction.

Noticing your talent, you’ve been asked by the government to become part of the investment committee for Australia’s Future Fund. One of your investment managers is an aggressive “market timer”. On the last day of each quarter, the Future Fund invests all of its money in either an ASX 200 index fund or cash in an endeavour to be invested in the best performing asset class during the coming quarter.

Question 1

What percentage of the Future Fund’s quarterly allocations need to be correct for you to be assured that the return from its market timing strategy outpaces that of a simply buying and holding an ASX 200 index fund?

  1. 50 percent
  2. 67 percent
  3. 86 percent
  4. 100 percent

 Question 2

When you shift out of stocks and into cash in anticipation of a broad-based decline in stock prices, the risk/reward ratio is tilted:

  1. Strongly in your favour
  2. Moderately in your favour
  3. Moderately against you
  4. Strongly against you

It turns out the odds are really stacked against you – the correct answer to question 1 is (c) – 86% – that’s a *lot* of good calls. To make matters worse, the correct answer to question 2 is (d) – a bad call will reduce your annual return by 1.4 times as much as a good one will increase it.

The biggest risk of market timing is being in cash and missing the relatively brief episodes during which equity markets earn all of their above-cash return. In the chart below, missing the 25 best days over a 21 year period halved your return. Investment returns are not, never have been, and never will be smooth. Returns come in fits and starts that are by definition unexpected.

MarketTimingIsRisky

If you’ve been tempted by the siren-song of market timing, tie yourself to the mast. Remember that one or two lucky calls does not a comfortable retirement make. Not only do you almost always have to be right to come out in front, if you’re wrong on those crucial 1% of days, it will be devastating to your returns. And rubbing salt into your wounds will be the added transaction costs and taxes that you had to pay along the way.

Join the discussion One Comment

  • Graham Wright says:

    Hello Todd
    I have no doubt about the statistic of the required number of good calls to be a winner in switching in and out of investments. However, your presentation suggests that the decision to switch is made simply by an “I think now is the time” basis such as the end of each month.

    I think the statistic should change if we introduce a reason for the change. An event may happen or has happened and may cause investors to change their behaviours. Now we have the “possibility”, “probability” or “certainty” that the market may move in a certain direction.

    If we make our decisions on “possible” movements, we are really gambling and the statistical number of successful decisions will remain relatively true. Where the decision is based on a “certainty”, the decision will be a winner because it is correct. Of course most people will recognise a “certainty” so the rewards will be intrinsic, not monetary.

    When the outcome is in the “probability” range, the correctness of our decision is dependent on our assessment of the probability of the predicted outcome occurring. Here, we range from gambling when the “probability” is closer to a “possibility,” to “knowing” when the outcome is closer to the “certainty” position. Our chances of being right more often increase as we make decisions closer to the “certainty” position.

    Then the greed mentality comes into play. “Possibilities” pay greater rewards on the few times they are correct and “certainties” provide intrinsic rather than monetary rewards but you are correct more often.

    The “probabilities” provide rewards ranging between the other two. The nature of people is to take a little more risk for a little more reward and thus follow a less “certain” or less “probable” outcome for the greater reward.

    Overcome the greed and make better decisions.

    Graham Wright

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