One of the most popular beliefs held by individual investors is that timing the market is a winning investment strategy. After all, who doesn’t want to buy low, right at the end of a bear market, and sell high, just before the next bear market begins. Unfortunately, ideas can’t be responsible for the people who believe in them.
No Way to Know
The evidence is very clear that professional mutual fund managers cannot predict the direction of the stock market. For example, a Goldman Sachs study examined mutual fund cash holdings from 1970 through 1989. In an effort to time the market, active fund managers raise their cash holdings when they believe the market will decline, and lower their cash holdings when they are bullish. The study found that mutual fund managers miscalled all nine major market turning points during the period.
The following example demonstrates the difficulty of timing the market, in part because so much of the market’s returns occur over such short and totally unpredictable periods. There are a total 1,020 months in the 85-year period from 1926 through 2010. The best 85 months (an average of just one month each year, or just 8.3 percent of the months) provided an average return of 10.7 percent. The remaining 935 months (91.7 percent of them) produced virtually no return (just 0.05 percent).
Famed investment manager Peter Lynch offered another example. He pointed out that an investor who followed a passive investment strategy and remained fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4 percent rate of return. If that investor missed out on just the best 10 months (or 2 percent of them), his return dropped 27 percent, to 8.3 percent. If the investor missed the best 20 months (or 4 percent of them), his return dropped 54 percent, to 6.1 percent. And finally, if the investor missed the best 40 months (or 8 percent of them), his return dropped 76 percent, all the way to 2.7 percent.
Do you really believe that there is anyone who can, before the fact, select the best 40 months in a 40-year period? Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
No Crystal Balls
Perhaps it was evidence like that cited above which compelled Fortune magazine to offer this warning in a May 1997 issue: “Let’s say it clearly: No one knows where the market is going—experts or novices, soothsayers or astrologers. That’s the simple truth.” Of course, these words of wisdom come from the same magazine that advises investors on whether or not the market is under- or overvalued, and on which active managers to choose when building a portfolio.
John Bogle, Vanguard’s legendary founder, said this about market timing: “After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
But perhaps renowned investor Bernard Baruch said it best: “Only liars manage to always be out during bad times and in during good times.”
Tactical Asset Allocation (TAA)
We can also look at the evidence on market timing by examining the performance of Tactical Asset Allocation (TAA) funds, an investment strategy that gained its original popularity in the 1980s. The financial crisis of 2008 has led to another surge in demand for funds using the TAA strategy. Morningstar classifies roughly 332 funds as tactical asset allocation funds. That’s up from just eight in 2007.
The objective of TAA is to provide better-than-benchmark returns with (possibly) lower volatility. This theoretically is accomplished by forecasting returns of two or more asset classes and varying the exposure (the percent allocation) accordingly. The varying exposure to different asset classes on which TAA depends is based on economic and/or market (technical) indicators. A TAA fund would then be measured against its benchmark.
While a TAA fund’s benchmark might be represented by a 60 percent allocation to the S&P 500 and a 40 percent allocation to the Barclays Aggregate Bond Index, the manager might well be allowed to have his or her allocation levels range from 5 percent to 50 percent for equities, 20 percent to 50 percent for bonds, and nothing to 45 percent for cash. In reality, TAA is just a fancy name for market timing. In other words, it’s a way to charge higher fees.
So, how has Morningstar’s Tactical Asset Allocation category performed relative to a 60/40 S&P 500 Index and Barclays Aggregate Bond Index portfolio? Morningstar reports that over the three years ending July 2014, these funds have gained an annual average of 7.8 percent, or 3.8 percent per year behind their benchmarks. And these findings are nothing new.
The Bottom Line
The bottom line is that stock market forecasts have about as much value as George Carlin’s Hippy Dippy Weatherman’s forecast: “Tonight’s weather is dark, followed by widely scattered light in the morning.”
Investors are well served to heed this warning from behavioral economist Richard Thaler in his book, “The Winner’s Curse”: If you are prepared to do something stupid repeatedly, there are many professionals happy to take your money.
This commentary originally appeared September 29 on MutualFunds.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE