Trying to Time the Market

Market timing is one of the all-time great myths of investing.  There is no strategy that consistently tells you when to be in the market and when to be out of it, and anyone who says otherwise usually has a market-timing service to sell you.

Here is an interesting study in the February 2001 issue of Financial Analysts Journal, which looked at the difference between buy-and-hold and market-timing strategies from 1926 through 1999 using a very elegant method. 

• The authors essentially mapped all of the possible market-timing variations between 1926 and 1999 with different switching frequencies.
• They assumed that for any given month, an investor could be either in T-bills or in stocks and then calculated the returns that would have resulted from all of hte possible combinations of those switches.  (There are 2^12 - or 4,096 - possible combinations between two assets over 12 months.) 
• Then they compared the results of a buy-and-hold strategy with all of the possible market-timing strategies to see what percentage of the timing combinations produced a return greater than simply buying and holding.

The answer?

About 1/3 of the possible monthly market-timing combinations beat the buy-and-hold strategy.  You may be thinking, "I have a 1 in 3 chance of beating the market if I try to time it.  I'll take those odds!"

But, consider these three issues:

1. The result in the paper cited previously overstate the benefits of timing because they looked at each year as a discrete period - which means they ignore the benefits of compounding (as long as you assume that the market will generally rise over long periods of time, that is).
2. Stock market returns are highly skewed - that is, the bulk of the returns (postive and negative) from any given year comes from relatively few days in that year.  This means that the risk of NOT being in the market is high for anyone looking to build wealth over a long period of time.
3. Morningstar has tracked thousand of funds over the past two decades.  Not a single one of these has been able to CONSISTENTLY time the market.  Sure, some funds have made the occasional great call, but none have posted any kind of superior track record by jumping frequently in and out of the market based on the signals generated by a quantitative model.

That is pretty powerful evidence that market timing is not a viable strategy because running a mutual fund is a very profitable business - if someone had figured out a way to reliably time the market, you can bet your life they'd have started a fund to do so.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey