Market Timing 101 (Part 1)

Key Points

  • The opportunity cost associated with the poor timing of initial investment allocations can be significant.
  • After missing out on a period of good performance some investors may be further compelled to employ additional timing measures that can further exacerbate underperformance.
  • Market timing, the tactical timing of when to be invested and when not to, although sensible at a high level, is far easier said than done.

Is it Time Yet!?

A common investment dilemma that you likely have experienced is the timing of an initial investment, and often there are two alternative concerns associated with this particular dilemma. In the first scenario, the market has just rallied, so you might be concerned that you are investing near the top. In the second scenario, the market has just experienced some turbulence, so you are concerned that the market may continue to fall. Thus, with either concern, you opt to “wait and see” before putting your hard-earned capital to work. But just how sensible is this strategy? And are you likely to come out ahead of the market by adopting this approach?

The tactical timing of when to be invested and when not to be invested is known as market timing, and this topic is a significant area of focus for academics and investing professionals alike.

Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods such as technical indicators or economic data. —Investopedia

Essentially successful active investing comes down to answering two simple questions, what to invest in, and when to invest in it, and market timing is all about the “when”. Given this, we’ll want to spend some time on seeing where the current research and the financial industry stands on all this. But before we go any further, let’s cover some basics.

No Big Deal, Right?

One big pitfall of trying to time an initial investment allocation is the potential that you might miss a solid period of good performance. We explored this notion in an earlier post, where we noted the significant opportunity cost an investor would experience by trying to time an optional entry point over 2017, a year in which the S&P 500® Index basically kept going up.

We noted that an investor would have missed out on about 20% in potential gains had the investor tried to wait for a correction (a fall of 10% from its high) in the S&P 500® Index over 2017, because the market essentially went up for the entire year, as depicted in Figure 1 below.

2018-10-18-S&P 500 Total Return for 2017
Figure 1. Growth of $10,000 invested in the S&P 500® Index (dividends reinvested) over 2017 (Source: data from S&P Dow Jones Indices)

No big deal, right? Our investor can just make it up by beating the market over the next ten years or so. Problem solved. But not so fast. Just how easy is it to catch-up to a benchmark after missing solid year of performance? Turns out it’s actually quite difficult.

One big hurdle to this notion is quite simple to take in—the stock market tends to go up over long periods. So if you plan on Investing Forever (read: a very long time) and you decide to wait for an opportune time to put some money to work, your money might miss the boat. In Figure 2 below, we can clearly observe this from the long-term trend of the S&P 500® Index Total Return since January 1, 1928 through December 31, 2017.

2018-11-26-Market Timing 101 (Part 1) Figure 1
Figure 2. S&P 500® Index (dividends reinvested) from 1928 through 2017, Logarithmic Scale. (Source: data from S&P Dow Jones Indices)

Note that the y-axis (the vertical axis) in the chart above is on a logarithmic scale, where each horizontal line represents a dollar amount that is ten times the previous. Given that the S&P 500® Index (in blue) from the chart looks like an upward sloping line, this means that the growth in wealth represented by the chart is actually exponential in nature.

After observing this long-term trend, you might be of the opinion that it makes the most sense to put your money to work in this index sooner rather than later instead of trying to time an optimal entry point. The notion is that with time you can ride out any bumps that you may experience by simply holding on to your position. And indeed, this is a key tenant of Investing Forever, and a strong reason why a passive investing strategy can make sense for most long-term investors, such as when saving for retirement; nevertheless, many investors still believe that timing an optimal entry point is the way to go, so let’s go ahead and explore this notion in further detail.

Gamblers Remorse

Here’s a quick hypothetical scenario. After falling behind the S&P 500® Index by 20% (as you would have had you decided to sit out 2017), how much would you need to return over the next 10 years to catch up if the index returns 7% each year over the next 10 years? Let’s go with this 7% assumption because this is around the average annual return for the S&P 500® Index since inception in 1928, with dividends reinvested and adjusted for inflation, but you can play around with these assumptions here.

Turns out our investor would need to average an annualized return of around 9.4% over a ten year period to catch up, or about 2.4% above the index each and every year for ten years. Sounds feasible, but 2.4% in annual excess returns (alpha) over a lifetime would place our investor as one of the best investors of all time. Nevertheless, let’s say our investor actually did end up pulling off this feat over just the next ten years. Was it luck or skill? Based upon what we’ve discussed so far, it’s probably luck given that most professionals can’t even seen to do much better.

In the estimation of Morningstar, actively managed portfolios that moved in and out of the market between 2004 and 2014 returned 1.5% less than passively managed portfolios. According to Morningstar, to gain any edge, active investors have to be correct 70% of the time, which is virtually impossible over that time span.

In the estimation of Morningstar, actively managed portfolios that moved in and out of the market between 2004 and 2014 returned 1.5% less than passively managed portfolios. According to Morningstar, to gain any edge, active investors have to be correct 70% of the time, which is virtually impossible over that time span. —Investopedia

Based upon the above reference, actively managed portfolios ended up with negative alpha on average. If our investor followed the lead of these actively managed portfolios by trying to further time the market for the next ten years after following behind in 2017, our investor would be more likely to fall further behind rather than catch up.

When the odds are against you, just as in a casino, the more you play the greater your chances of losing.

However, it gets worse, as we haven’t discussed the impact of taxes in all this, but we’ll consider this particular issue later in this series. But next, let’s digest what Nobel Laureate, William Sharpe has to say about this in Part 2 of this series.