Does Market Timing Work?
When investors look at the long-term historical performance of stocks many believe that there may be a way to predict when to buy and sell securities in financial markets. If investors were able to anticipate when the unusually high or low returns will end, they could sell or buy securities at advantageous times and earn higher returns through market timing.
Although long term gains from market timing are highly unlikely, there will always be some investors who have positive results from timing activities particularly in the short run. The danger is the leap of logic which presumes that the good market timing result is caused by superior predictive ability rather than random chance.
When it comes to money management people have a lot of opinions but misconceptions abound. While many investors believe market timing is a strategy that works, the overwhelming body of evidence points to the reality that attempts at market timing produce inferior long-term results compared to a passive buy-and-hold index fund investing approach.
Why then do so many investors believe market timing is a viable strategy? One reason is that it is promoted heavily by active investment advisors and Wall Street pundits. These people need clients to believe they have the expertise and insider knowledge to identify and profit from market trends. Gaining client assets with false promises lines their pockets even as it risks doing active harm to their clients’ prospects for long-term portfolio growth.
The financial media reinforces this misconception by lavishing attention on the latest investment gurus who recently made the right moves, thereby fueling the hope of those who wish there were a way to earn high returns without incurring risk. But the news media often fails to report the string of failures and market miscalculations of these very same so-called "brilliant" investors.
Investors would do better to take off their blinders and examine why market timing is a hollow strategy. It is not a reliably predictive tool. To get it right, one would have to identify precise turning points in the market before they occur, in order to profit from short-term events and avoid downturns. This requires perfect foresight, data and timing. Yes, investors may say, but sometimes it works, right? The answer remains no, it doesn’t. Sometimes guesswork and predictions work but the long-term gains from market timing are highly unlikely.
Still, many investors prefer to live with false hope and wishful thinking that with the right timing, they too can strike it rich. It is easier to believe in something possible but implausible than to take a long hard look at evidence that may dash one’s hopes.
Long-term buy and hold index fund investing is the opposite of market timing. It makes no false promises and eschews guesswork. It is based on proven financial theory and data from more than a century of investment results. Index fund investing will reap the rewards of the market through up and down cycles. Sometimes those rewards will be explosively positive, and sometimes the down cycles will arrive with a vengeance. But the index-fund investor understands that it is much smarter to remain invested throughout all market cycles.
Let’s consider one 39-year period to see why the index investor has a huge strategic advantage over the market timer. Missing the best 25 trading days between January 1970 and December 2009 would have slashed S&P 500 Index returns from 9.87% to 6.01%. Looked at another way, missing the best 25 days out of 10,000 trading days in those 39 years would have eliminated 39% of gains compared to simply buying and holding the S&P 500 Index without interruption.
Further, the best days to be in the market often follow disastrous stock sell-offs, precisely when timers’ money is on the sidelines. Twelve of the 25 best trading days of the aforementioned 39-year period occurred between September 2008 and March 2009, a period in which the S&P 500 fell 37.7%. Market-timers who had retreated would have missed these spectacular rebounds. We saw evidence of this again in March and April 2020.
Testing Mean-Reversion Rules
Let’s dig deeper into why market timing is an impossibility. Several large studies have examined whether there are patterns of market behavior that would make it a reliable tool for maximizing gains and minimizing losses. If patterns could be recognized, they could be exploited by all investors with access to the right data.
Mean reversion is the idea that higher-than-average returns will be followed by lower-than-average returns (and vice versa). In other words, the price of a security will revert back to the mean over time. Higher-than-average and lower-than-average prices can be predictive trends for market timers, who consider the relationship between the current price and the moving average of past price movements. (The moving average is the arithmetic average of any given number of past closing prices of a stock or index.) By focusing on this data, timers believe they can identify a market trend without being distracted by day-to-day price volatility.
But what does mean reversion look like in the real world? Should a pattern be visible over three years? Five years? Does the mean itself remain fixed over time? What should the magnitude of the pattern look like? If a pattern’s magnitude is small, changing the composition of a portfolio might not provide much benefit to an investor. But if investors could anticipate that returns are likely to turn negative, they could potentially avoid periods of underperformance. The challenge, then, is to find evidence of mean-reverting patterns using real world data. This evidence must be strong enough to support a consistent, profitable trading strategy. It should demonstrate what mean reversion looks like in terms of magnitude and/or timing.
Jim Davis of Dimensional Funds studied mean reversion by examining premiums associated with the market, size, value and profitability of companies in 15 stock markets around the world, including the US. He then tested several different trading rules on this data set. “Moving average” rules look for high average premiums followed by low average premiums. “Run space” rules examine what happens after a premium has been positive for several years in a row. After running data sets on multiple rules, Davis ended up with 780 test results.
The sheer number of tests meant that some positive results were likely to show up simply by random chance. For instance, if 5000 people repeatedly flip a coin, we would expect about five of them to flip 10 heads in a row by random chance. In a similar way, some of the trading rules produced strongly positive returns. But that doesn't mean that they would continue to do so in the future.
Looking at the results for each trading rule, Davis calculated an excess return, which is the extra return that the rule generated above a strategy that maintained a consistent focus on the premium. The majority of the excess returns were negative. Of the minority that were positive, many were fairly small. However, a small number of test results produced large excess returns. Davis hypothesized that there may be a couple of reasons for these positive results.
The first is the fact that he ran so many tests. The second is that in several cases, the high return was due to a single year of data. When trading results are due to a single year, it doesn't create confidence that similar returns will persist into the future.
What can we conclude from the Davis study? First, we cannot rule out the existence of mean reversion from 780 tests, but these tests show no evidence that it can produce consistently profitable trading strategies. Long-term gains from market timing are highly unlikely, but short-term gains can sometimes show up. Statistically this is what we’d expect. Over any given period of time, some investors do very well while others do poorly; there is always a wide dispersion of investor experiences. But based on the Davis study, the presumption that a better experience is due to superior market timing would be an error in logic.
This leads us to another study that gets to the heart of why market timing is unreliable as a predictive strategy.
The Problem with Market Timing
In a classic research paper on stock market timing published in the late 1980s, Trinity Investment Management studied 9 peak-to-peak market cycles. The first cycle began on May 29, 1946 and the last cycle ended August 25, 1987. This study remains relevant today because it reveals the mind-twisting impossibility of predicting when bull and bear markets will begin and end, not to mention which parts of each market cycle will be most profitable.
Trinity observed the following:
• Over all cycles between 1946 and 1987, there were approximately 1.7 times as many up months (309) as down months (187).
• The average bull market was up 104.8 percent, while the average bear market dropped negative -28 percent.
• Bull markets lasted nearly three times as long as bear markets; 41 months for the up months versus 14 months for the down months. Yet even within the bear markets, on average, the market was up in 3 to 4 months out of every 10.
• During the bull markets, on average, 8 months (out of the 41-month average duration) accounted for more than 60 percent of the total return achieved.
There are some important takeaways from this study. First, the average advance in a bull market is more than sufficient to regain the ground lost during a bear market. Second, bear markets are only knowable in the rear-view mirror. This is reinforced by the fact that 3 or 4 months out of 10 were up months, even during a bear market.
This study demonstrates that superior returns from investing in stocks don’t accrue in a uniform or predictable manner, but in sudden bursts. These positive surges often occur when pessimism is running high. That's consistent with expectations that market bottoms are reached when investors are most pessimistic. At that point, there’s nowhere to go but up. That said, turning points—including the greatest optimism or deepest pessimism—can’t be predicted. They can only be observed retrospectively.
Again, to circle back to points made earlier in this article, the central problem with market timing is that it based purely on guesswork and predictions. A disproportionate percentage of total gains from a bull market occur very rapidly at the beginning of a market recovery—but we cannot know when that will be. If a market timer is on the sidelines in cash during this critical time, he or she may miss the best opportunity for large gains.
Embrace Risk Strategically
We will never stop hearing news of market timers who made the right moves, at just the right time. We will read of those who predicted this or that bull or bear market. Some will be proven correct, or partly correct, in retrospect. Many will be wrong. The fact that financial news sources flood us with predictions—particularly during turbulent times—highlights our deep desire for direction and certainty. Who doesn’t wish for a way to take full advantage of a bull market, while avoiding the pain of a bear market?
Yet all the evidence points to the impossibility of successfully timing the market. This doesn’t stop many investors from clinging to false hope. As we stated at the outset, it’s easy to believe in something that’s impossible but plausible, but hard to believe in evidence that dashes our hopes.
To face the question of whether market timing is possible forces investors to acknowledge that they really have just two choices. The first is to periodically face the pain and uncertainty of a bear market. The second is to forego investing in common stocks altogether, thereby sacrificing the possibility of real capital growth over the long-term.
There is no middle ground. Risk and reward cannot be separated. For the buy-and-hold passive and index fund investor, risk is addressed in the process of asset allocation, not in guesswork about market timing. Paradoxically, only by embracing risk can superior long-term results be achieved. Achieving long-term goals is not the result of market timing, but of establishing and adhering to proven investment strategy.
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This article pulls from books and articles. References include:
1. Asset Allocation: Balancing Financial Risk, Roger Gibson, McGraw Hill
2. Winning the Loser's Game: Timeless Strategies for Successful Investing, Charles D. Ellis, McGraw Hill
3. Stocks for the Long Run, Jeremy J. Siegel, McGraw Hill
4. A Random Walk Down Wall Street, Burton G. Malkiel, W. W. Norton & Company
5. Can You Predict a Good Time to Buy and Sell Stocks?, Jim Davis, Dimensional Fund Advisors LP