February 11th, 2019 | by Gregg S. Fisher, CFA, "Invest with Reason"
Does Market Timing Work?
- A return of volatility to equity markets has brought the topic of market timing into relief again.
- Using more than 90 years of market data, we compared a market-timing approach to a long-term portfolio allocation strategy with periodic rebalancing.
- Market timers need to be very accurate in selling prior to market peaks and reinvesting shortly after market troughs to outperform strategic allocation.
- In most cases, strategic allocation outperforms.
The recent whipsaw movements in stock markets have left many investors pondering whether now is a time to enter or to exit stocks. During the fourth quarter of 2018, the S&P 500 Index slumped 13.5%, capping the first negative year for the US market since 2008. Then stocks suddenly rebounded in January and are up 8% (S&P 500 Index) year-to-date to February 8. I thought now was an opportune time to bring some research discipline to bear on the rather controversial (and emotional) topic of stock-market timing.
The financial news media are filled with self-described market experts who pronounce that a correction is coming (last year we did come within a whisper of a 20% decline in the S&P 500 Index), or a nasty bear market, and therefore advise investors to jettison stocks (or, if they read a rebound in the tea leaves, they advocate adding to equity positions). Some of these pundits may use trend-following charts, such as 200-day moving averages, to come to a market-timing conclusion. Other analysts may use valuation yardsticks and, for example, advise investors to sell when stocks are in the top decile of valuation by history, or buy when they’re priced in the lowest-valuation decile.
Strategic Allocation vs. Market Timing
We looked back over more than nine decades of market data, and analyzed just how difficult it is to time markets successfully. Here’s how we conducted our study: We compared the performance of a 60/40 balanced portfolio (60% S&P 500 Index/40% 5-year US Treasury Notes) with that of a market timer. For the 60/40 portfolio, we rebalanced equities back to the 60% neutral allocation when market movements caused equities to move more than 10% relative to their target allocation (i.e., up to a 66% portfolio weighting or down to 54%). The market timer also starts with a 60/40 portfolio, but dumps equities and holds 100% bonds when he expects a market correction, and moves back to 60% equities when he feels we’re past the market bottom.
Beginning in 1926, we ran about 3,250 scenarios in which we shifted equities to bonds from between zero and 18 months prior to the market peak, and reallocated to equities from zero to 18 months after the actual market trough. We then compared the annualized return to the next market peak of this market-timing approach to that of the buy-and-hold, but actively rebalanced, 60/40 portfolio.
Exhibit 1 illustrates some of the results in a bar chart. For example, if an investor has perfect timing (how many of those have you ever met?) and sells stocks precisely at the peak and buys them back at the very bottom of the market, his portfolio will outperform a systematically managed balanced strategy by 2.2 percentage points annualized. But if the investor’s timing is off by more than six months on both the timing of when to sell out of the market and when to buy back into equities, he would have been better off doing nothing more than sticking to his (systematically rebalanced) 60/40 strategic allocation. The results for market timing only get worse from there, as a market timer who’s a year early in selling and a year late in buying will trail by 1.6 points annualized.
In our study, overall the 60/40 strategic allocation method held the upper hand in 56% of scenarios across 18 months prior to market peaks and after market troughs, and in virtually all scenarios where the investors misjudged the end and beginning of a market downturn by six months or greater. In reality, the discrepancy is even larger since many market-timers are off by more than 18 months—we all know investors who bailed out of stocks in 2008 and never reinvested, or declared 2013 the top of the market and sold.
Some market observers may claim clairvoyance and the ability to foretell market peaks and troughs. In fact, those with such abilities are few and far between. Most mortal investors may be better off adhering to a disciplined approach such as holding a periodically rebalanced, strategically allocated portfolio.