The Trouble with Market Timing

03/28/2013 11:00 am EST

Focus: STRATEGIES

John Reese

Founder and CEO, Validea.com And Validea Capital Management

This should be no surprise to the savvy investor: many claim to be "market timers," but most investors and advisors fall far short, writes John Reese of Validea Hot List.

As stocks continue to head higher and higher, it gets more and more tempting to try to call a market top.

After all, the last time stocks were this high, few investors realized they were about to be hit by one of the sharpest, most painful bear markets of their lifetime. It’s thus natural to think back on those events and fear that similar pain is going to follow again this time.

That, however, is a very, very dangerous game, and a couple recent studies showed just how difficult—and detrimental to your portfolio—trying to time the market can be.

Dalbar, the research group that tracks how well mutual-fund investors actually do compared to the funds in which they invest, found that over the past 20 years through December, the average individual stock mutual fund investor earned 4.25% per year, while the S&P 500 returned 8.21%, The New York Times reported.

A $10,000 investment at 4.25% annualized would be worth $22,989 after 20 years; at 8.2%, it would be worth $48,456 after 20 years. The gap in performance is due in part to the fees mutual funds charge, but also to investors making emotional decisions to jump in and out of the market at inopportune times.

Dalbar President Louis S. Harvey says, “Make sure that you select a reasonably defensive asset allocation strategy first,” adding, “The most important thing once you have a strategy is to find a way to actually stick with it.”

Meanwhile, Mark Hulbert—who for decades has been monitoring the performance of dozens of investment newsletters through his Hulbert Financial Digest—looked at returns since October 2007 of the more than 100 market-timing newsletters and web-based advisors monitored by HFD.

In a recent Barron’s column, Hulbert reported that no one called the top in 2007 and bottom in 2009 on the exact days. But that’s an incredibly tough standard. So he used a relaxed standard—a much relaxed standard—and found that the results were still very poor.

Hulbert considered an advisor to have called both the top and bottom if they had decreased their allocation to stocks by at least 25% within a month of the October 9, 2007 top, and increased their stock allocation by at least 25% within a month of the March 9, 2009 bottom.

He found that of 140 strategies tracked by HFD, only 15 had significantly lower equity exposure a month after the 2007 top. Of those, just six had markedly higher equity exposure a month after the bottom.

“In other words,” Hulbert said, “96% of the market-timing strategies monitored by the HFD failed to jump over these seemingly modest hurdles.”

What’s more, the six that did meet the timing criteria had other issues. Each gave a number of other buy and sell signals in the intervening periods “that had the unfortunate effect of frittering away the gains they otherwise would have realized if they had left well enough alone,” Hulbert says.

He did say that about 25% of the market timers he tracks have beaten the market since stocks hit their 2007 high, but “none of them did so by getting out at or near the top and getting in at or near the bottom.”

Like Harvey, Hulbert also says discipline is crucial when following a market-timing approach. And he says investors shouldn’t expect they’ll come close to timing market tops and bottoms correctly.

“Realistic expectations are crucial,” he says. “Without them, you are more likely to try something rash and end up losing even more money.
 
I agree completely. There are some effective market-timing strategies out there, and if you do feel strongly about using one, a few words of advice: Make sure the approach you choose is quantitative in nature—do not try to jump in and out of the market based on hunches or guesswork.

In addition, the approach should have a proven, long-term track record of success. And, most importantly, once you find that approach stick with it, no matter how rocky the road gets in the short term.

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