Is there value in trying to time your entry & exit from the market?

This article aims to address the pros and cons of the investment strategy known as ‘market timing’.

Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions and the strategy is based on the outlook for the market as a whole, rather than for a particular financial asset.

The aim of the market timing strategy is essentially to switch between growth assets and defensive assets in order to generate a better risk adjusted return than that from holding a strategic combination of both asset types. When the future looks bleak, the market timer reduces their exposure to growth assets and increases their exposure to defensive assets. When the future begins to look rosier, they will begin to increase their exposure to growth assets at the expense of defensive assets.

With the benefit of hindsight, this seems like an eminently plausible and simple way to enhance your wealth. Compared to a passive strategy, they need to get two decisions right – the timing of when to move away from their strategic target exposure and the timing of when to move back. Proponents of the strategy argue that they do not have to be correct 100% of the time, they simply must be right more often than they are wrong. It can also be argued that the market timer can reduce their volatility by minimising the slide in down markets, allowing them to preserve their capital for when the market picks up again.

The passive strategy proponents argue that implementation and effectiveness of the market timing strategy is more difficult than it seems. The cost of implementation[1] means that market timers have to be more than 50% right with their timing decisions. Statistically, luck says that over time the average of right versus wrong decisions for market timers will be 50%. If you need to be (say) 60% right in order to breakeven then you need more than luck to be working for you.

Passive strategists also argue that whilst most market timing strategies are based on the in depth analysis of current market and economic information, this does not increase their chances of success. The allure of knowing more does not necessarily translate into better investment outcomes. They also note that market timing is also often a reaction to market volatility – in other words, it is strategy that is more often than not applied after the event.

And finally, while market timers can reduce their volatility by protecting their downside, they more often than not miss out on a large slice of the upside of staying invested. In essence the market timer seems more concerned with minimising their volatility (or downside risk) than they are about the risk of maintaining their purchasing power.

To illustrate the two options, market timer versus strategic investor, we decided to compare the outcomes using historical data. For the sake of the exercise we assumed that there were only two asset classes to choose from – cash and shares. We also assume that each are purists and believe fully in their strategy. Accordingly, the market timer will switch between a holding of either 100% cash or 100% shares at any point in time. The strategic investor will hold a combination of cash and shares in the same proportion throughout all market conditions. They reweight the portfolio annually in order to maintain a constant proportion between cash and shares.

For the market timer we assume that they remain invested in shares at all times but will switch to cash when shares under perform. When the return for shares for the most recent 12 months falls below the return for cash, the market timer will switch from shares to cash. Conversely, when the 12 month return of cash falls below that of shares, the market timer will switch back to shares. We assume that most market timers have a longer term view than that of a market trader and will therefore hold any position for a minimum of three months and will implement each decision after three months of confirming data.

Applying these rules to actual market data since January 1980 using Cash and Australian Shares[2] as the two asset classes, the market timer achieved the following outcome:

The market timer was able to enhance their return above Cash and yet reduce their volatility below that of a purely Shares only holder. The volatility of their return, as measured by the Annualised Standard Deviation, was 15% lower than that of an all Share exposure (14.98 versus 17.59).

So, what about the Strategic Investor? We replicated a portfolio structure that produced the same level of volatility (risk) over the time period as experienced by the Market Timer. The Strategic Investor who held a portfolio with 15% exposure to Cash and 85% exposure to Shares achieved the following outcomes:

The Strategic approach paid off handsomely. The risk adjusted return benefit of 1.43% per annum would have resulted in the Strategic Investor’s portfolio being 43% higher than the Market Timer’s portfolio over the 28 year period – without taking any additional risk. This was a period that included its fair share of market volatility including the 1987 crash and the tech bubble deflation.

And this result is understated. We have not included the performance drag of the costs associated with implementing the market timing decisions (transaction costs and capital gains tax).

Summary

The desire to market time is inherent in all humans – we love to stamp our mark on things; we are inherently over confident and we all possess an inbuilt ‘prediction addiction’. In most situations in life when things aren’t’ going as we want or expect them, a little added effort and activity is the solution. However, in the game of investing, more activity is not necessarily the answer. Good investors recognise their natural human instinct to react to market volatility and work hard on overcoming their ‘need’ to react. They are disciplined with their actions and patient with respect to results. Over the long term, the odds are in their favour.

[1] Transactions costs and capital gains tax
[2] Cash is represented by the UBS Warburg 90 day Bank Bill Index & Australian Shares is represented by S&P/ASX 300 Accumulation Index.