There aren’t many investment rules that are set in stone. Most of them come with exceptions, caveats and qualifications. But more than six decades of academic evidence, plus my own experience through years of volatile markets, make the bottom line abundantly clear: Thou shalt not time the market.
To help make sense of the relatively wild ride that the markets often deliver, let’s explore five market-timing temptations investors experience during market downturns, and why each is more likely a recipe for long-term disappointment than savvy success for anyone seeking to build or preserve personal wealth.
The five notorious market-timing tactics during market downturns I’ll address are:
1. “Get me out of this mess!”
2. “Markets have become inefficient. I should capitalize on that.”
3. “I’ll get out now, and jump back in when the market recovers.”
4. “It’s obvious we’re in for bad returns. Why not avoid them?”
5. “Tactical defense makes sense to me.”
“Get Me Out of This Mess!”
My response: There’s never a good time to market time.
Especially when the markets head south, it can be hard to believe that your best course of action is to do nothing, at least when it comes to your trading habits. It can be even harder to stay staunchly inactive when things seem to be going from bad to worse. Many investors reach what BAM ALLIANCE Director of Research Larry Swedroe describes as their “Get Me Out!” (or “GMO”) panic point, abandoning their market positions.
This is an especially egregious form of market timing. It may feel as if you’re making a wise decision, but in reality, your brain is sending silent signals that are overpowering your rational resolve with panic-driven instincts. A bounty of research has shown that our tendencies for financial panic are no exception to this base rule.
Know that what follows is a message I would not repeat if I did not truly believe it remained in your best interest: Buy and hold. Rebalance. Stay the course. This is advice I’ve reiterated again and again. It leaves no room for dodging in and out of markets in a costly attempt to stay one step ahead of them.
Over the long term, this advice has served investors well. Yet, in the face of persistent and/or severe market downturns, you tend to hear a common refrain from investors. It goes something like this: “Okay, so that advice has worked in the past. But this time is different. The market just keeps going down and down. There must be a better way than to sit and do nothing.”
I, like most advisors, empathize with investors who feel they should be reacting to ongoing bad news. But the better approach has always been (and always will be) one based on scientific evidence, not on anyone’s opinion about the market’s next moves.
Time-tested, peer-reviewed evidence does not offer perfect predictions. Nothing does. But it is the most reliable guidance available to investors. How would you feel about a doctor who gave advice based exclusively on his or her opinions, without considering the medical research that appears in publications such as the New England Journal of Medicine? In finance we have equivalent publications, such as The Journal of Finance and the Journal of Portfolio Management, upon which advice can and should be based.
And while the particulars of a given current event are always at least a little different than what you may have seen in the past, the underlying, evidence-based strategy remains the same.
“Markets Have Become Inefficient.”
My response: Show me the evidence for that. (Hint: I’ve not found any.)
For you to believe that you should abandon a long-term strategy that’s served you well so far, you would first have to be convinced that markets have become less efficient. In other words, you’d have to believe that the markets were now mispricing assets and slower to react to new information.
It is hard to imagine that markets have gotten slower at reacting to news when it seems that nearly daily we hear of new and more powerful technology being applied around the globe. There is ample evidence that price adjustments are occurring within nanoseconds of new information hitting the wires.
I’ve also seen no evidence that active mutual fund or hedge fund managers have improved on their abilities to profit on supposedly mispriced assets, especially net of the costs involved. In fact, quite the opposite:
- Regularly updated data and analyses such as those from Dalbar and the S&P Dow Jones Indices continue to substantiate the inability of active managers to capitalize on market inefficiencies.
- In a March 2014 article and again in September 2015, Larry Swedroe offered still more evidence indicating that market timing remains ill-advised across U.S., international and emerging markets.
- An October 2015 study coming out of Cornell University offered additional empirical analysis on why it may be even tougher than already assumed for active managers to outperform their appropriate benchmarks.
In short, even if the markets are not perfectly efficient, they have been and continue to be efficient enough, making it extremely difficult to outsmart them. If they were not, the proof would soon be evident. Active managers would be able to consistently profit from the anomalies. Instead, periodic falling prices are expected as part of the market’s normal (if unpleasant) operations as it responds to news that’s worse than had been expected. Whatever happens next likewise depends not on good or bad news, but on whether it’s better or worse news than collectively anticipated. This remains inherently unknown information that nobody can predict.
“I’ll Get Back in When It’s Safe.”
My response: The greater risk is the risk of missing the recovery.
There is yet another reason you should avoid market timing: Much of the market’s returns occur during brief, unpredictable and often downright counterintuitive periods. For example, who would have thought that March 2009 was the perfect time to jump back into the market? At that point, it looked like things would never get better. And yet, annual returns for the CRSP 1-10 Index surged from -36.7 in 2008 to 28.8 in 2009.
Besides, to successfully get in and out of the market at all the right times, you have to be right not once but twice. And deciding when to get out is easy compared to deciding when to get back in. Investors who go to cash may be “whipsawed.” They will flee after a severe drop, miss a big rally and jump back in only to experience another severe loss. They often end up in a worse situation than if they had simply stayed the course.
That is why I believe going all to cash or similar, presumably safe harbors is not a winning strategy. Consider financial advisor and columnist Barry Ritholtz’s assessment: “Time, not timing, is key to investing success.” Or AQR founder Cliff Asness’ sentiment: “Every time someone says, ‘There is a lot of cash on the sidelines,’ a tiny part of my soul dies. There are no sidelines.”
“It’s Obvious That We’re in for Bad Returns.”
My response: There’s a big difference between “obvious” information and useful wisdom.
In terms of investing, information can be described as the many facts increasingly available to all of us. Wisdom is information that can be exploited to generate excess (or above-market) returns. When asked why they are so willing to abandon their well-designed financial plans, many investors say something like: “Isn’t it obvious that the situation is terrible right now?” Socioeconomic crises, debilitating sovereign debt, jobs going overseas, market mayhem, terrorism, global warming … there is always an extensive laundry list.
So consider the following wisdom.
The market already knows. When bad news is obvious, it’s already – and very rapidly – reflected in current market prices. After all, that is why the prices have already gone down.
Today’s risks generate tomorrow’s rewards. When things are bad, the market is perceived as risky and valuations are low, which means that expected returns are high. Why would a rational investor sell low when the empirical evidence indicates that future expected returns are higher?
For every seller, there is a buyer. Remember that trading is a zero-sum game. For each trader who panics and sells, another one has been willing to buy at the same, low price. Those buying during times of distress believe the market price already reflects the high risks. Clearly, heading for the hills is never as “obvious” as it may seem.
The evidence is against you. The historical evidence is that individual investors persistently demonstrate a pattern of buying high (after bull markets, when risk premiums are low) and selling low (after bear markets, when risk premiums are high).
This destructive behavior is evidenced in a number of studies demonstrating that investors typically underperform the very mutual funds in which they invest. A classic study to this effect is Brad Barber and Terrance Odean’s “Trading Is Hazardous to Your Wealth.” More recent analysis by Research Affiliates’ Jason Hsu indicates that similar tendencies exist even among institutional investors. If you’re still not convinced, revisit Larry Swedroe’s aforementioned September 2015 article, “Don’t Sell During Volatility.”
These studies and many more are reflected in what BAM ALLIANCE Director of Investor Education Carl Richards refers to as investors’ return-damaging “behavior gap.” This concept is reflected in his book of the same title. The simple solution to avoid losing money in your own behavior gap is to stay disciplined during market turmoil.
“Tactical Defense Makes Sense to Me.”
My response: Tactical market-timing is speculative, not defensive.
Investing history is filled with examples of defensive tactics aimed at timing market exposure based on observable patterns of past performance. Unfortunately, the realized returns haven’t matched the promise.
Vanguard examined the performance of several different tactical signals to see if they actually translated into better risk-adjusted returns. As one example, the authors studied whether investors could improve their portfolio performance by defensively shifting equity exposure toward less cyclical, lower-beta sectors (such as health care, consumer staples or utilities). This strategy is based on documented evidence that certain sectors tend to thrive in different stages of the business cycle.
They found that “a defensive investment strategy based on the leading signals of bear markets and recessions (focusing primarily on recessions) would not have resulted in better results than a buy-and-hold strategy.” Hurdles they found included “the low predictive power of even the best signals of bear markets and recessions as well as potentially high transaction and tax costs.”
Another signal they examined was the presence of an inverted yield curve (in which short-term interest rates exceed long-term rates). An inverted yield curve is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is noisy: “For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.”
They also examined the forward-looking price-to-earnings ratio. The concept is based on the idea that a bear-market signal is received when the ratio is at historic highs. Unfortunately, this indicator is also noisy and, thus, has provided no value.
While the historical record shows that various sectors have tended to outperform during tough times, Vanguard concluded that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”
This conclusion is further substantiated in a CBS Moneywatch article from Larry Swedroe, in which he assesses trading focused on the Schiller P/E ratio. He observes: “The academic research shows that while no one metric is really a great predictor of future returns, we do know that relying on past returns when predicting future returns is likely a mistake.”
One final nail in this coffin: A 2014 study by Robert Novy-Marx of the University of Rochester found that any of the perceived benefits gained from these sorts of defensive strategies were well explained by three common market factors (size, profitability and relative valuations). At best, this means that the exercise is not expected to add value in its own right. Worse, it threatens to knock you off course from the returns that could have been yours through a disciplined, evidence-based investment approach. And it will cost you trading dollars either way.
Noted author Peter Bernstein provided this inspiring insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”
Based on the best available evidence, avoiding market timing remains the most likely way to achieve your goals. Consider the words of Jim Parker of Dimensional Fund Advisors:
“[M]any investors bought into supposedly sophisticated trading strategies during the financial crisis that left them on the sidelines in the subsequent rebound, which has driven prices in many markets to multiyear or record highs. The simpler approach is to adhere to three core principles: Markets reflect the aggregate expectations of investors about risk and return, diversification helps reduce uncertainty, and you can add value by structuring a portfolio focused on known market premiums. For the individual investor, the essential add-ons to this are staying disciplined and keeping a lid on fees and costs.”
There is, however, one condition under which you may be wise to alter your portfolio. That’s when your personal circumstances or goals have changed. If the assumptions upon which you built your personalized plan no longer hold true, then your ability, willingness and need to take on market risk may have changed. As a result, your portfolio’s risk exposures might need to be adjusted as well. This isn’t about market timing though. It’s about life – your life.
In short: buy, hold and rebalance. Above all, stay the course according to your long-term plan, making adjustments only when your own goals have changed.
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