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.
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?
- 50 percent
- 67 percent
- 86 percent
- 100 percent
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:
- Strongly in your favour
- Moderately in your favour
- Moderately against you
- 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.
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.