This quote from Hugh Johnson is more accurate than many advisors want the public to know: "The most intelligent way to begin managing money is to confess you don't have a clue where the markets are going."  The stock and bond markets are affected by so many influences, and those influences change direction and importance so frequently, that short-term predictions are not much more than guesses.

Almost everybody expects that in the very long term, the markets will go up. But many investors have trouble waiting for the “very long term” to happen. The pain of periods like 2000 and the beginning of 2001 is just too great for some investors to tolerate.

Market timing can’t take away all the pain, and it can’t reverse the effects of a bear market. But it can reduce risk by keeping conservative investors on the sidelines during downturns while getting them in during bull markets. And timing can let aggressive investors effectively use more volatile assets to increase returns without taking the risk of being wiped out.

At its most fundamental level, timing is a tool for managing risk. If markets never went down, or if investors never got nervous about paper losses, timing might not be necessary. But as the stock market showed last year and early this year, major losses can happen when many people don’t expect them. Some people think paper losses aren’t real. But losses are not theoretical. Just ask any retiree who lost 20 percent of a growth fund portfolio last year plus another 15 percent loss in the month of February 2001.

In an ideal world, a timing system would alert an investor to the perfect time to buy, at the lowest possible price, and the perfect time to sell, at the highest possible price. No system can consistently do that. And even if you found such a system, it would be met with great skepticism and resistance.

The bottom of a market cycle is when sentiment is the gloomiest; few people feel like buying, even though they will later realize that is just what they should have done. Likewise, the peak of a market is when enthusiasm is highest; few people feel like bailing out, even though later many will wish they had.

It’s unrealistic to expect any system to tell you the best times to get in and out of the market. A more reasonable goal is to identify times when, based on historical patterns, the probability is higher for gains than losses (a buy signal) or vice versa ( a sell signal).

If you visualize the market’s action as a sine wave, with smoothly flowing curves going up and down, you could wish for a timing system that alerted you when you were in the bottom part of an upward move (so you could buy) and again in the upper part of a downward move (so you could sell). That’s what we strive for in the systems we use.

Many investors, perhaps most, use market timing, whether they realize it or not. Whenever you decide to get into a market or “lighten up” your exposure to the market for reasons other than a change in your own needs, you are market timing. By that I mean you are determining that this is a “good time” or a “bad time” to be in a particular market. I’m not talking about replacing one growth fund with another that invests in the same part of the market.

Market timing happens when you replace a mutual fund with cash or vice versa, or when you decide to get out of one market, say large-cap stocks, and into another market, say mid-cap stocks. If you buy or sell because you suddenly need money or suddenly have money to invest, that’s not market timing. But if you buy or sell because of what’s happening in the market, that’s timing.

Most individual investors time the market based on forecasts, predictions, intuition, analysis or (the biggest) emotions. We don’t. Our market timing is done strictly with mechanical systems that react to existing trends in the markets. We use proprietary systems, of which we don’t disclose the details.

But later in this article we’ll show you a simple timing system that any investor can use to time purchases and sales of mutual funds. And we’ll show you how this system, which has been well known to investors for decades, would have performed in the past. You’ll see that timing can be a powerful tool to help you reduce the risk of investments while you still get a reasonable return.

The chief advantage of timing is that you don’t leave your wealth completely exposed to the risk of the market all the time. In the systems we use, we typically spend 25 to 60 percent of the time at least partially in money-market funds, which are virtually risk-free. When everything goes right, timing lets you make a series of short-term profitable investments, each separated by a time on the sidelines in cash.

The four chief disadvantages of timing are that 1) it is rare when “everything goes right,” 2) timing requires you to buy and sell when your emotions (and often the TV commentators and financial writers) are telling you to do the opposite, 3) timing requires constant attention to your portfolio and 4) unless you do it in a tax-sheltered account, timing subjects most if not all of your profits to income taxes, at ordinary income rates, every year.

We’ve written extensively in the past about these psychological hurdles to timing, and I won’t repeat the whole discussion here. But we have concluded that relatively few investors have the tenacity, discipline and faith required to be successful market timers. For more on that subject, go to the newsletter archives on our Web site and find articles titled: “Do You Have What it Takes to be a Successful Market Timer?” and “Which is Better, Market Timing or Buy and Hold?”

I want to show you a very simple timing system that can be applied to mutual funds. It won’t be equally effective on all funds. But over long periods of time it is certain to reduce the risk of investing in an asset; and it may increase the return of the asset.

This system is called the 100-day moving average. To calculate this for a fund, simply record each daily closing price of the fund for 100 days, which corresponds to 20 weeks without holidays. Divide the total of those prices by 100 and you have the fund’s 100-day moving average. Each business day, remove the oldest price and add the newest one to compute a new total. You can see that this average will move slowly up and down.

Each day, compare the latest fund price to this moving average. If the price is above the average, you want to be invested in the fund. If the price is below the average, you want to be out of the fund and in cash. Each time the price moves above or below the average represents either a buy or a sell signal. That’s all there is to it.

You can start using the 100-day system any time. On the first day you compute the average, stay in cash (or sell the fund if you already own it) if the fund’s price is below the average. If the fund’s price is above the average, either buy the fund or keep it if you already own it.

Keeping track of 100 days of prices is tedious unless you use a computer spreadsheet. But fortunately there’s an even easier way to make this comparison every day, if you have Internet access. Go to www.Bigcharts.com and type the fund’s ticker symbol in the box at the top of the page. Then click on the “Interactive Charting” button. On the left side of the resulting page, set the time frame for two months and daily and set the indicators for SMA (simple moving average) and 100. Then click the “draw chart” button. If you find the resulting graph easy to understand, you can save your chart settings. Next time you go to this site, you will get a graph just like the one you are looking at, only with updated data.

Now I’d like to direct your attention to Table 1 that shows the year-by-year results of timing the Standard & Poor's 500 Index with this 100-day moving average system. The first column for each year shows the results of the index without timing, on a buy-and-hold basis. Pay particular attention to the figures in the bottom eight lines, which show various measurements of risk.

Assumptions:
1. S&P500 Buy & Hold returns were obtained from Dimensional Fund Advisors.
2. Same-Day Trading.
3. Commercial Paper Rates are used to simulate money market yields.
4. The simple moving average system is applied to the S&P500 total return index.
5. Leverage is applied daily.

The next column shows the results of using the 100-day moving average. There were 19 calendar years in which timing outperformed the buy-and-hold approach. Buy-and-hold outperformed in the other 40 calendar years. Overall, timing had a lower annualized return, 12.7 percent instead of 13.3 percent without timing. That is a major difference over 59 years.

But just as significant, timing reduced risk. The worst month and the worst one, three and five-year periods all would have been much easier to tolerate with timing. Timing produced smaller drawdowns, too. (A drawdown is the greatest percentage loss you experience before breaking even.)

I said earlier that it’s rare that “everything goes right” with timing. This table shows that. The 100-day moving average timing system produced 301 “round trip” trades. You can think of each round trip as a temporary investment starting with a purchase and ending with a sale. In an ideal world, each sale or round trip would result in a profit. But only 92 of those 301 round trips were profitable. The other 209 were unprofitable.

If it weren’t for one other statistic, this would lead most people to a “no-brainer” decision to forget about timing. But the average loss on the unprofitable round trips was only 0.9 percent, while the average gain on profitable ones was 10 percent. What market timing did, in other words, was force investors to accept many small losses (the largest loss on a round trip in 59 years was 6.9 percent) in return for a smaller number of big gains (the largest gain on a round trip was 88 percent).

Uninformed critics of timing often make statements like “You have to be right more than 70 percent of the time for timing to work.” Those statements are wrong because they don’t take into account the size of the resulting gains and losses.

Still, timing exacts an emotional toll and does not provide lasting comfort. The longest string of consecutive losing round trips was 14; the longest string of consecutive winning ones was just four. In other words, timing requires a considerable amount of faith. It also requires long spells of inactivity and flurries of activity. In 1942, this timing system generated only one trade; but in 1943 there were 14 trades, getting an investor more emotionally involved. In 1947, there were 28 trades, the equivalent of a purchase or a sale about every two weeks for a full year! Quite a bit later in the period under study, there was a spell of eight years, from 1963 through 1970, with no more than nine trades in any one year.

Another interesting statistic emerges from this study: Timing kept an investor in the market only 72 percent of the time; that is how market-timing reduces risk. The other 28 percent of the time, the investor was in cash and on the sidelines, protected from bear markets. But those figures are only averages. Notice that this simple timing system managed to keep an investor in the market 100 percent of the time in 1954, when the S&P 500 Index was up 52.6 percent, and to keep an investor out of the market more than 91 percent of the time in 1974, when the market dropped 26.5 percent.

Nevertheless, the annualized return of the timing column over 59 years is lower than without timing, and this points to another significant weakness of timing: In bull markets, timing does not have any way to add value to a buy-and-hold approach. Once you are in the market, you cannot do any better because of a timing system than you could without one.

One excellent way to overcome this drawback is through the use of leverage, borrowing money from a broker, for instance, to increase your exposure to the market when your timing signal indicates you should be invested. When your timing system indicates a sell signal, you pay back the borrowed money and retreat to cash until the next buy signal.

It used to be that leverage was possible only through margin loans made by brokers, which involved paying interest and suffering “margin calls” that can wipe out an investor’s position in a bear market. But in the past decade several mutual funds have simulated leverage, giving timers an inexpensive, convenient way to combine timing with leverage.

The next column in that table shows the hypothetical results of timing the S&P 500 Index with a beta of 1.5, equivalent to borrowing 50 cents for every dollar of your own capital whenever you invest. That is comparable to investing in an enhanced index fund like Rydex Nova.

Because timing is not perfect, we would expect a simple 100-day moving average system to generate larger average losses as well as larger average gains. And the table bears that out, using the same 301 round trips. With leverage of 1.5, average losses increased to a still-tiny 1.4 percent, while average gains increased to 15.7 percent.

This column’s annualized return over 59 years was 18.3 percent, an enormous advantage over the buy-and-hold return. If an investor started with $1,000 in 1942 and kept it invested through 2000 (an unreasonably long time for any investor, we realize), it would have grown to $1.58 million without timing. At an annualized return of 18.3 percent, the same $1,000 would have grown to $20.2 million.

The fourth column in the table, after each year, shows results of using this timing system with a beta of 2.0, equivalent to borrowing $1 for every $1 of your own money when you are invested. This is comparable to investing in an enhanced index fund like ProFunds UltraBull. Here again, the average losses are greater (1.9 percent), and so are the average gains, 22.1 percent.

At this column’s annualized return rate of 23.7 percent, $1,000 invested in 1942 would have grown to $281.7 million by the end of 2000. And that, by the way, is after a brutal 45 percent loss in 2000.

Before we leave this table I want to point out something else. As you can see from the bottom lines showing results in the worst periods, timing reduced the risk of investing in the market. Each variation of timing, with and without leverage, improved on the worst one-month and the worst five-year periods. Timing without leverage reduced risk by every measurement, and timing with a beta of 1.5 reduced risk in the worst one-month, three-month, one-year and five-year periods. Thus that variation can truly be said to have produced more return with less risk.

Table 2 shows the same information for the Nasdaq Composite Index from 1972 through 2000.

The buy-and-hold column shows a 13.7 percent annualized return through 2000, even after last year’s 36.8 percent loss, which was the worst calendar year performance since the index was formed. (Investors who are sure this index will rebound soon might be interested to look at its history in 1973 and 1974, when it had back-to-back losses of more than 30 percent.)

In the next column you’ll see that timing without leverage boosted the annualized return to 19.6 percent, while reducing risk by every measurement. The difference between 29 years of a 13.7 percent return (buy-and-hold) and a 19.6 percent return (timing) is enormous. An investment of $1,000 at the start of 1972 would have grown to $41,405 without timing; using the simple 100-day moving average timing system, that return would have been $188,472.

You can see what happened when timing was combined with leverage. The returns of that $1,000 investment would have been $1,285,550 with a beta of 1.5 and $7,950,232 with a beta of 2.0. And remember, those last two numbers are after subtracting substantial losses in 2000.

Here’s something else I find quite interesting: Before 2000, the worst calendar year without timing produced a loss of 35.1 percent for buy-and-hold, while the worst calendar year with timing was 1993, which produced losses of 1.7 percent without leverage, 3.6 percent with 1.5 beta leverage and 6 percent with 2.0 beta leverage.

It’s also interesting to note that during that worst year for timing, the untimed index was up 10.6 percent, illustrating that timing sometimes behaves quite differently than buy-and-hold. If you looked at only that year, you’d easily conclude that timing “doesn’t work.” But it’s very hard to reach that same conclusion looking at these longer time periods, even including 2000.

Looking at calendar years, we see the Nasdaq without timing had seven negative years. Yet this simple timing system without leverage reduced that to only two down years. Adding leverage of 2.0 brought that up to four losing years; but more important, this strategy produced some huge calendar-year gains. As good as it was on a buy-and-hold basis, the Nasdaq has had only three calendar years with gains of more than 50 percent. But timing and leverage of 2.0 produced 11 years of gains over 50 percent, including two years with triple-digit gains.

Here again, timing produced many more unprofitable round trips than profitable ones. But as with the Standard & Poor's 500 Index, the average profit (for instance, 15.9 percent without leverage) was much greater than the average loss (in this case 1.4 percent).

If you didn’t know about 2000, you could conclude that this timing system, combined with leverage of 2.0, would be a dynamite way to invest in the part of the market represented by the Nasdaq 100 Index.

But what is an investor to make of 2000? While last year was well within the range of normal years for the Standard & Poor's 500 Index, it was the worst-ever year for the Nasdaq market. Even more troubling, while timing and leverage improved on buy-and-hold over most of the past 29 years, last year was a huge disappointment.

It’s possible that 2000 was just an unusual combination that isn’t likely to happen again for many years. Or last year’s returns could be the start of a series of disastrous years for the Nasdaq. We have no way to know.

I am inclined to give more weight to the 28 years from 1972 through 2000 than to just the most recent calendar year. That suggests to me that market timing, especially when it is combined with leverage, remains an excellent way to invest in the Nasdaq 100 Index.

A buy-and-hold approach to investing is a way to seek long-term growth. But it’s not a legitimate way to try to preserve your capital. The only way for buy-and-hold investors to preserve capital is to mix enough bonds or bond funds into the portfolio to bring the overall volatility within their risk tolerance.

Market timing, on the other hand, is aimed at alternatively preserving capital and growing it. For conservative accounts with timing, we still recommend including bond funds.

Market timing is certainly not a feel-good approach to investing. Taking lots of small losses – sometimes many in a row – is no fun. But most of the time, timing has improved returns in years that a buy-and-hold approach falters.

Investors often have a choice of accepting a strategy that is likely to produce maximum gains along with maximum pain or one that is likely to produce reasonable gains along with reduced pain. Timing is an example of the latter. Here’s my evidence:

On the S&P 500 Index table, you’ll see that the index without timing had a dozen negative years. In 11 of those 12 years, the 100-day moving average timing system produced better returns; only in 2000 did timing fail to improve the results of a down year for the index. In the seven negative years for the Nasdaq 100 Index, timing improved the results every time, without exception. I think that’s a pretty compelling story in favor of timing.

If you are seeking higher returns, use timing with a more volatile asset. A good example is switching from the Standard & Poor's 500 Index to the Nasdaq 100 Index. This involves taking more risk, but the rewards are there, and timing dulls the pain. The Nasdaq market has a higher standard deviation, greater losses and larger drawdowns than the S&P 500 Index. But it also has produced higher returns, when used with this timing system.

If you are seeking a similar return but with reduced risk, use timing with the same asset you would otherwise buy and hold. Adding timing without leverage often reduces your return. But it always reduces risk by taking investors out of the markets some of the time.

The most challenging number on this whole table for me is the 24.2 percent loss last year on the Standard & Poor's 500 Index with timing. This was the worst year for market timing during this whole 59-year period, and it has led some investors to conclude that timing is broken and has just stopped working.

I don’t believe that. It’s interesting to note that for both the Standard & Poor's 500 Index and the Nasdaq, the 100-day simple moving average got investors out of the market late in October 2000 and had not issued a buy signal by the time this was written in mid-March 2001. That means investors who followed this system missed two of the stock market’s worst months, November 2000 (in which the S&P 500 Index lost 8 percent and the Nasdaq lost 22.9 percent) and February 2001 (in which the S&P 500 Index fell 9.2 percent and the Nasdaq dropped 22.4 percent).

To put that into perspective, those who used this simple timing system avoided four-month cumulative losses (November 2000 through February 2001) of 13.2 percent on the Standard & Poor's 500 Index and 36.2 percent on the Nasdaq. Avoiding losses like that is what market timing is all about.

I personally have most of my family’s investments governed by market timing, though it is not governed by this 100-day moving average system. Drawdowns like those we experienced last year are painful and discouraging. But they don’t last forever.

I have strong faith that the future holds a silver lining in which the markets will turn up strongly again. I want to be ready for it, and that means I want to have money available to invest when that happens. I cannot afford – or at least I am not willing – to lose the majority of my wealth while I’m waiting. That’s why I count on market timing to keep me away from the worst danger periods.

Timing certainly doesn’t always work perfectly, as we have seen. But it works well enough for me to count on timing so I’ll be there to see another day.

 

 

 

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