Market timing

Market timing is the strategy of making buying or selling decisions of financial assets by attempting to predict future price movements. With markets continuing to experience continued volatility, investors begin to question whether they should exit and re-enter the market in order to avoid losses.

Investors who believe in market timing base their strategy on the basis that long term investors miss out on gains by riding out volatility rather than guaranteeing returns via market-timed exits. The method of exiting and re-entering the market is believed to allow for investors to realise larger profits and minimise losses by moving out of sectors before a drawback, thereby avoiding the volatility associated with equities. One of the most productive forms of this strategy is to hold common stocks during bull markets and cash equivalents during bear markets.

A policy involving accurate market timing has two advantages being that returns are both higher on average and subject to less variability. However, accuracy in predictions about broad market movements is the most important element in implementing a market timing strategy. A study by famed financial professor and economist William Sharpe concluded that an investor who attempts to time the market must be right roughly three times out of four, merely to match the overall performance of those competitors who don’t. The high rate of success required to implement market timing strategy profitably is largely due to the transactions costs associated with making switches as well as the suboptimal performance experienced should an investor be invested in cash at the incorrect time.

Whether market timing is possible is a matter of opinion and what can be said with certainty is it is very difficult to time the market consistently over the long run successfully, as the saying goes, “Time in the market is better than timing the market”. The below article highlights some of the risks and costs involved in implementing a market timing strategy as well as that bull markets are far more important than bear markets.

The Cost of Market Timing

One of the biggest costs of market timing is being out when the market unexpectedly surges upward, potentially missing some of the best-performing moments. The importance of remaining invested in the market and the risk of market timing is illustrated in the graph below, which outlines the value of $10,000 invested into an S&P 500 index fund from 1980 to 2018 with varying periods of inactivity in the market.

Source: The Simple Dollar. Data as at 31 December 2018.

The risk of implementing a marketing strategy and the potential costs are highlighted by the fact that in order to produce alpha over a buy and hold strategy, an investor must be correct at least 75% or more of the time, when exiting and entering markets. In addition, as highlighted above, should an investor miss out on just the five best days of returns during a thirty-eight year investment period, they will sacrifice approximately 35% of their returns. Based upon these two factors alone, it is clear that a long-term investment in a well-diversified portfolio is more likely to deliver better returns than trying to profit from turning points in the market.

Bull vs. Bear Markets

The chart below outlines the historical performance of the S&P 500 index throughout the US bull and bear markets from January 1926 to September 2018. What is clear is that bull markets last far longer than bear markets, the average bull market lasts 9.1 years compared to the average bear market of only 1.4 years as well as the fact that comparative losses experienced during bear markets are much smaller than the gains experienced during bear markets, with bull markets delivering an average cumulative gain of 480% compared to bear markets experiencing an average cumulative loss of 41%.

Source: First Trust Advisors, L.P., Bloomberg, 1926 through September 30, 2018.

Conclusion

Declining or volatile markets can create strong emotional reactions, during these periods, the key is to have conviction in your investment strategy and understand that it is far more important to be in the market when it is rising than to avoid the more infrequent periods of market decline.

The difficulty of market timing is further compounded by the fact that best and the worst days in the market tend to be clustered in narrow time periods. According to the J.P. Morgan study, six of the ten best days occurred within two weeks of the ten worst days.

Therefore, the periods following a significant market downturn are the most important in ensuring long term investment success and producing good returns and that missing even a small number of days could severely negatively impact performance.

Prolonged periods of poor market performance can take a toll on even the most patient investor, however as indicated above, the key is to ride out these bumpy periods, remain patient and trust in your investment process, as the key to long term investment success will be time in the market and not timing the market.