|
EDITOR'S NOTE: This article was first published in 1994
in Paul Merriman's "Fund Exchange" newsletter, the predecessor to
FundAdvice.com. We have kept it on this site all this time because its
message is just as timely now as it was then.
Market
timing works, and it works well for people who actually practice it as
a discipline. In theory, every investor is capable of following the
disciplines of timing. But not everybody has the right emotional makeup
to do timing right. In real life, most people who try are ultimately
unsuccessful. Timing puts investors on the front lines, face to face
with the realities of the market, every business day. To be a
successful timer, you’ve got to buy and sell without flinching even
when you don’t feel like it. You’ve got to follow your discipline even
when you’re sure it’s a mistake. You’ve got to do it even when you
don’t understand why your timing system is telling you to act. Nike had
it right: "Just do it." But it’s so much easier to say than do!
This month I’m going to share with you a list of 10
keys to being a successful market timer. And I’ll tell you some
uncomfortable truths about timing, what it’s really like when it’s not
fun. But even the best tips in the world won’t be of any value to you
unless you put them into practice. And no matter what you think, you
probably won’t do that unless you have the right emotional temperament
to be a timer.
Timing is not for sissies.
Sometimes it takes strong faith and a strong stomach. I like this quote
from the legendary Benjamin Graham: "To achieve satisfactory results is
easier than most people realize. To achieve superior results is harder
than it looks."
Here are six questions to help you determine if you have what it takes. (Long-time Fund Exchange readers
may recognize this topic from an issue we published five years ago.)
There are no right or wrong answers, only what’s true for you.
Six questions
1. Do you have the necessary perseverance?
Timing
can get you in real trouble if you try it for awhile, become
discouraged and then abandon your plan in favor of something you find
more palatable. If you let your feelings guide you, you’re likely to
bail out of a timing strategy at the very worst time, when your
investments are down. Can you adopt a strategy and stick to it for the
long term? Can you follow the system regardless of how you feel about
it and regardless of what’s going on around you? Can you resist the
temptations to act on impulse? Can you ignore the many "hot tips" you
may come upon every week?
2. Are you
independent and self-assured enough to resist the temptation to
constantly look over your shoulder to see how somebody else is doing?
There
aren’t many certainties about investing, but here’s something I can
guarantee: no matter how your investments are doing, there will always
be somebody who has recently outperformed you and seems to have struck
it rich. Nervous investors constantly look over their shoulders, hoping
to find somebody who has found "the one true path" to wealth. That path
is a myth, and nervous investors don’t make good timers. Confident,
successful investors know what they want and need, adopt a strategy to
achieve their objectives and stick with that strategy regardless of
what others are doing. If your goal is to increase your assets by 10
percent a year, and a timing system lets you achieve that, can you be
satisfied even when other people are making 12 percent or 15 percent or
even 20 percent? If so, you may have what it takes to succeed as a
timer.
3. Can you accept that your portfolio will underperform the market?
This should be obvious, but you would be surprised to know how many people forget it. A timing system is not designed
to produce the same returns as the untimed market. When you outperform
the market, you are likely to be pleased. But your pleasure may be mild
compared with the fury or betrayal you can experience when your
portfolio is under-performing and when your timing system produces a
losing trade. That’s especially true when you just "knew" that the
signal you got from your system was the wrong thing to do.
4. Can you accept that your timing system will be imperfect?
Imperfection
is one of the media’s biggest criticisms of timing. When you are
underperforming and experiencing losing trades, that media criticism
may shake your confidence. The media often says market timing requires
you to be right twice: when you buy and when you sell, in contrast to a
buy-and-hold approach in which you have to be right only once: when you
buy. Most of the time, you can count on your system to get you into or
out of the market "too soon" or "too late" to catch the tops and
bottoms. If getting out at the very top and getting back in at the very
bottom are your goals, timing is guaranteed to let you down. And if
that failure will drive you nuts, think twice before embarking on a
timing strategy, because what you will perceive as timing mistakes will
erode or destroy your willingness to follow the discipline. Your goal
should not be to achieve perfection. It should be to put the
probabilities on your side. And a good timing strategy will do that.
5. Can you ignore the mass media?
Almost
unanimously, the popular press seems to have a blind spot when it comes
to timing. They say timers are misguided, and this view is widely
echoed by the mutual fund and brokerage industries. Can you pull out of
the market when everybody else is either getting in or already making
money? Can you get back in when your friends, colleagues, the media and
possibly your own gut are telling you it’s a dumb idea?
6. Are you decisive?
Some
people stew and fret and delay making decisions, even when they are
convinced they should do something. They are unlikely to be successful
timers. Successful timing requires quick action to move into and out of
markets. One of the most obvious truths about timing (and one of the
most widely overlooked) is that by the time your friends, your
colleagues, your gut and the experts all agree on what you should do,
it’s already far too late for you to extract the maximum opportunity
from it. If you usually take lots of time to make decisions, this is
not a suitable arena for you.
10 Keys to Successful
Market Timing
If
you have the emotional makeup for it, timing can reduce your risks and
enhance your returns. If you’re satisfied that you have what it takes
to be a market timer, here are the best tips I know for doing it
successfully. They aren’t necessarily listed in order of priority. In
fact, I suggest that you regard each one of them as the top priority.
1. Use mechanical strategies.
Timing
financial markets is already plenty hard without worrying about making
predictions or (even worse) thinking you have to decide who is right
when smart economists and savvy analysts make conflicting forecasts and
draw different conclusions. If you leave the final decisions to
subjective factors, you will never be sure what you are supposed to do
at any given moment. That will cause you anxiety and delay. And you’ll
have a system you can’t count on. Rely primarily on trend-following
systems that are based mainly on trends that are impacted by actual
prices in the market. There’s nothing speculative about prices. They
reflect what buyers and sellers are doing, and that’s about as reliable
an indicator of the direction of the market as you can find.
2. Do not -- repeat DO NOT -- pay much attention to the effect of every trade.
The
majority of individual trades will be irrelevant to your long-term
results. If you feel you must focus on each trade and agonize over what
it means, that’s a sure sign you are not cut out to be a successful
timer. Dwelling on each trade is a sure way to drive yourself nuts, and
it won’t improve your results at all.
3. Use timing systems that are right for you and your temperament.
The
perfect strategy for you will match your time horizon, will respect
your emotional needs and will operate within your tolerance for risk
and change. There are short-term systems that trade frequently,
long-term systems that trade infrequently and intermediate-term systems
that typically trade two to six times a year. Over long periods of
time, no group has an inherent return advantage over the others. But
the practical and emotional differences are important. If you have a
strong desire to perform closely in synch with the market, use
short-term systems, which are good at quickly reacting to today’s
highly volatile market swings. However, short-term systems demand that
you make many trades, and each trade has potential tax consequences
unless you are investing in a tax-sheltered account. The volume of
trades demands a lot of attention, produces a lot of paperwork and
tests the patience of many mutual funds, which sometimes won’t accept
accounts from very active timers. If on the other hand you have a
strong aversion to whipsaws, you can use long-term systems. But doing
so will sometimes make you wait for a move of 20 percent or more before
you buy or sell. For the best compromise, do as we do: Use
intermediate-term systems. This level of activity is likely to be
accepted by most mutual funds and is not too demanding emotionally.
4. Use multiple timing systems, stick with them and let them act independently in your portfolio.
Even
the most productive system from the past may be a mediocre performer in
the future, and the reverse could also be the case. We use four U.S.
equity timing models, each of which governs 25 percent of our
portfolio. We have faith in the systems as a group. But we don’t have
enough faith in any one system to let it govern the whole portfolio.
You shouldn’t either. Just as you should not chase recent performance
in your choice of mutual funds or asset classes, do not chase recent
high-flying timing systems. One of the smartest timers in this
business, a fellow newsletter publisher whose work I respect, has
averaged about 9 percent over the past decade. He chooses good timing
systems, which have produced average returns of more than 18 percent
before he adopts them. But he doesn’t stick with those systems.
Whenever the system he has been using disappoints him, he finds another
one that would not have done so, based on real or hypothetical past
performance, and then he switches to that system. In theory, this may
seem like a valid way to search for the very finest system on the
planet. But in truth, such "superstar" timing models simply do not
exist. They are a myth. Good performance one year doesn’t mean anything
about performance the next year – not anything. This is one of the
hardest facts for investors to accept, but it’s true. Therefore, we
believe your best bet is to find several robust timing models and stick
with them.
5. Remember that whether you
use a buy-and-hold approach or market timing, asset allocation is the
most important investment decision you will make as an investor.
Use
many assets or asset classes that move up and down at different times
and at different speeds. Include international diversification, whether
you invest in equities, bonds or both. Just as you never know which
timing model will be the star performer in a given quarter or year, you
never know which asset class will be the overachiever and which will be
the laggard.
6. Follow your systems and your strategy.
Put
them into action without fail and without exception. Remember this
Chinese proverb: "He who knows but does not act, still does not know."
If you do only one thing right and everything else wrong, make sure
this is the one thing you do right. This is the most essential key of
all. If buying diet books and exercise equipment took off pounds,
obesity would not be a major health concern. You can devise the
greatest portfolio in the history of investing, but it will do you no
good unless you commit your money to it. The greatest timing models do
you no good unless you apply them. Therefore, do whatever is necessary
to get it done.
7. Before you start timing, take off the rose-colored glasses, if you are wearing them.
Focus
in advance on the difficulties you can expect as well as the ultimate
rewards you hope to achieve. Accepting the rewards of success will be
easy. But you’ll never get to the finish line unless you can deal with
the hurdles along the track. Know the level of interim losses you are
likely to encounter with your strategy, and make sure you are willing
to accept them. In the early 1970s, buy-and-hold investors in the
Standard & Poor’s 500 Index suffered a 39 percent loss in one year.
Even timing can be ugly. In our Worldwide Equity strategy, all our
back-testing has failed to produce a decline as high as 15 percent in
any 12-month period. Yet we believe that any strategy with the
potential to produce returns of 13 to 15 percent a year also has the
potential to lose 15 percent in a year, so that’s the figure we use
when we project the expected worst-case scenario. Bottom line: Do not
expect magic from any timing system.
8. Give timing enough time to work. In the short term, anything can happen.
In
the long term, if you have chosen a strategy carefully and you follow
the discipline, you should be rewarded accordingly. But how long is
long enough? There are two places to look for the answer. The first is
in your own psychology. Do you normally undertake long-term projects or
strategies, comfortable knowing that you’ll have to wait for any
payoff? If so, you may be a good candidate for market timing. But if on
the other hand you are usually quick to judge the success or failure of
something you start, and if you need instant gratification, you’ll
probably have trouble being a successful market timer. The second place
to look for the answer is in statistics and history. Arm yourself (or
have your manager do this for you) with the past statistical
performance, either real or hypothetical, of your proposed investment.
Over the longest period for which you have data, determine the depth of
the largest drawdown. Find out how long it took to return to
break-even. One of our most aggressive timing programs, which we call
by the shorthand of +2 to -1, meaning it attempts to double the
performance of large U.S. stocks when the market is rising and to do
the opposite of the market during declines, once took nearly two years
to recover from a 20 percent drawdown. Are you prepared to endure that
in order to make returns of more than 20 percent? Here’s an even
tougher example of the extraordinary patience required of investors: In
1973 and 1974, the S&P 500 declined by 44.9 percent. The index
eventually regained its pre-decline level. But it took 66 months for
some investors just to break even. Unless you are sure you’d stick with
a strategy through the longest historical drawdown for which you have
data, don’t embark on that strategy.
9. Unless you are absolutely committed to being a market timer, use both timing and buy-and-hold.
This
gives you two non-correlated approaches that will have differing
results in any given period. Over long periods, carefully chosen
investments in similar assets may generate similar returns with
buy-and-hold and market timing. But in the meantime, the average of the
two may give you lower losses, less risk and (perhaps most important)
less anxiety than either market timing or buy-and-hold alone. This
combination may be more appealing to many people than the peaks and
valleys of each approach separately.
10. Make sure you understand in advance the realities of market timing.
And
make sure you are prepared for them. I cannot emphasize this point too
much, so I hope you’ll read the following overview. If you invest money
that’s governed by timing and you’re surprised by everything that
happens to your investment, you will always feel off balance. You’ll
come to dislike and distrust timing. And even if you follow your
system, timing will produce anxiety for you. That is just the opposite of what it’s intended to do.
The realities of market timing
I’ve
never done a study on the topic, but I suspect airline pilots who use
market timing have above-average success rates. In their jobs, they
train themselves for trouble. Using simulators, they go through all
sorts of disaster situations in advance. Over and over and over again
they practice the worst scenarios, learning to recognize early warning
signs of trouble, learning what to do, learning the capabilities of
their aircraft. This is not fun. It is often upsetting and
nerve-wracking, even though it’s just practice. But when real trouble
hits in the skies, those pilots can go into immediate action, focusing
on what must be done instead of being paralyzed with fear. Simulator
training "seems completely real, not a game at all," says one of my
clients who is a veteran pilot. "It gives me more confidence in the
actual flying because I have been put through the wringer."
I
can’t put you in an investment simulator. But in the following
discussion, I’ll try to give you graphic descriptions of some of the
realities of timing. To get the most value out of this, take the time
to imagine each of the following points in enough detail that you
experience it in your gut as well as your brain.
Market
timing systems are based on patterns of activity in the past. Every
system that you are likely to hear about works well when it is applied
to historical data. If it didn’t work historically, you would never
hear about it. But patterns change, and the future is always the great
unknown. A system developed for the market patterns of the 1970s, which
included a major bear market that lasted two years, would have saved
investors from a big decline. But that wasn’t what you needed in the
1980s, which were characterized by a long bull market. And a system
developed to be ideal in the 1980s would not have done well if it was
back-tested in the 1970s. So far in the 1990s, any defensive strategy
at all has been more likely to hurt investors than help them. We can’t
see into the future any more than anyone else, and we can’t know what
types of trading patterns our timing models will have to deal with. So
we use timing models developed over all three decades.
If
your emotional security depends on understanding what’s happening with
your investments at any given time, market timing will be tough. The
performance and direction of market timing will often defy your best
efforts to understand them. And they’ll defy common sense. Without
timing, the movements of the market may seem possible to understand.
Every day, innumerable explanations of every blip are published and
broadcast on television, radio, in magazines and newspapers and on the
Internet. Economic and market trends often persist, and thus they seem
at least slightly rational. But all that changes when you begin timing
your investments. Unless you developed your timing models yourself and
you understand them intimately, or unless you are the one crunching the
numbers every day, you won’t know how those systems actually work.
You’ll be asking yourself to buy and sell on faith. And the cause of
your short-term results may remain a mystery, because timing
performance depends on how your models interact with the patterns of
the market. Your results from year to year, quarter to quarter and
month to month may seem random.
Most of us
are in the habit of thinking that whatever has just happened will
continue happening. But with market timing, that just isn’t so.
Performance in the immediate future will not be influenced a bit by
that of the immediate past. That means you will never know what to
expect next. To put yourself through a "timing simulator" on this
point, imagine you know all the monthly returns of a particular
strategy over a 20-year period in which the strategy was successful.
Many of those monthly returns, of course, will be positive, and a
significant number will represent losses. Now imagine that you write
each return on a card, put all the cards in a hat and start drawing the
cards at random. And imagine that you start with a pile of poker chips.
Whenever you draw a positive return, you receive more chips. But when
your return is negative, you have to give up some of your chips to "the
bank" in this game. If the first half-dozen cards you draw are all
positive, you’ll feel pretty confident. And you’ll expect the good
times to continue. But if you suddenly draw a card representing a loss,
your euphoria could vanish quickly. And if the very first card you draw
is a significant loss and you have to give up some of your chips,
you’ll probably start wondering how much you really want to play this
game. And even though your brain knows that the drawing is all random,
if you draw two negative cards in a row and see your pile of chips
disappearing, you may start to feel as if you’re on "a negative roll"
and you may start to believe that the next quarter will be like the
last one. Yet the next card you draw won’t be predictable at all. It’s
easy to see all this when you’re just playing a game with poker chips.
But it’s harder in real life. For example, in the third quarter last
year, our conservative Worldwide Balanced strategy, allocated 25
percent each in U.S. stocks and U.S. bonds, international stocks and
international bonds, produced a return of 3.88 percent, very
satisfactory for a portfolio invested 50 percent in bonds, in the third
quarter last year. But that was followed by a loss of 3.05
percent in the fourth quarter. Most investors in this strategy, at
least those we know of, stuck with it. But they experienced significant
anxiety at the loss and the shock of a sharp reversal in what they had
thought was a positive trend. The same phenomenon happened, with more
dramatic numbers, in our more aggressive strategies. Some investors
entered those programs last summer, when the U.S. stock market was
sizzling, and then were shocked to experience big fourth-quarter losses
so quickly after they had invested. Some, believing the losses were
more likely to continue than to reverse, bailed out. Had they been
willing to endure a little longer, they would have experienced a small
gain in January followed by double-digit gains in February that would
have restored much of their 1997 losses. But of course there was no way
to know that in advance.
Most timers won’t
tell you this, but all market timing systems are "optimized" to fit the
past. That means they are based on data that is carefully selected to
"work" at getting in and out of the market at the right times. Think of
it through this analogy. Imagine we were trying to put together an
enhanced version of the Standard & Poor’s 500 Index, based on the
past 30 years. Based on hindsight, we could probably significantly
improve the performance of the index with only a few simple changes.
For instance, we could conveniently "remove" the worst-performing
industry of stocks from the index along with any companies that went
bankrupt in the past 30 years. That would remove a good chunk of the
"garbage" that dragged down performance in the past. And to add a dose
of positive return, we could triple the weightings in the new index of
a few selected stocks, say Microsoft, Intel and Dell. We’d get a new
"index" that in the past would have produced significantly better
returns than the real S&P 500. We might believe we have discovered
something valuable. But it doesn’t take a rocket scientist to figure
out that this strategy has little chance of producing superior
performance over the next 30 years. This simple example makes
it easy to see how you can tinker with past data to produce a "system"
that looks good on paper. This practice, called "data-mining," involves
using the benefit of hindsight to study historical data and extract
bits and pieces of information that conveniently fit into some
philosophy or some notion of reality. Academic researchers would be
quick to tell you that any conclusions you draw from data-mining are
invalid and unreliable guides to the future. But every market timing
system is based on some form of data-mining, or to use another term,
some level of "optimization." The only way you can devise a timing
model is to figure out what would have worked in some past period, then
apply your findings to other periods. Necessarily, every market timing
model is based on optimization. The problem is that some systems, like
the enhanced S&P 500 example, are over-optimized to the point that
they toss out the "garbage of the past" in a way that is unlikely to be
reliable in the future. For instance, we recently looked at a system
that had a few "rules" for when to issue a buy signal, and then added a
filter saying such a buy could be issued only during four specific
months each year. That system looks wonderful on paper because it
throws out the unproductive buys in the past from the other eight
calendar months. There’s no ironclad rule for determining which systems
are robust, or appropriately optimized, and which are over-optimized.
But in general terms, look for simpler systems instead of more complex
ones. A simpler system is less likely than a very complex one to
produce extraordinary hypothetical returns. But the simpler system is more likely to behave as you would expect.
To
be a successful investor, you need a long-term perspective and the
ability to ignore short-term movements as essentially "noise." This may
be relatively easy for buy-and-hold investors. But market timing will
draw you into the process and require you to focus on the short term.
You’ll not only have to track short-term movements, you’ll have to act
on them. And then you’ll have to immediately ignore them. Sometimes
that’s not easy, believe me. In real life, smart people often take a
final "gut check" of their feelings before they make any major move.
But when you’re following a mechanical strategy, you have to eliminate
this common-sense step and simply take action. This can be tough to do.
You will have long periods when you will
underperform the market or outperform it. You’ll need to widen your
concept of normal, expected activity to include being in the market when it’s going down and out of
the market when it’s going up. Sometimes you’ll earn less than
money-market-fund rates. And if you use timing to take short positions,
sometimes you will lose money when other people are making it.
Can you accept that as part of the normal course of events in your
investing life? If not, don’t invest in such a strategy.
Even
a great timing system may give you bum results. This should be obvious,
but market timing adds a layer of complication to investing, another
opportunity to be right or wrong. Your timing model may make all the
proper calls about the market, but if you apply that timing to a fund
that does something other than the market, your results will be better
or worse than what you might expect. This is another reason to use
multiple systems and multiple assets.
The
bottom line for me is that timing is very challenging. I believe that
for most investors, the best route to success is to have somebody else
make the actual timing moves for you. You can have it done by a
professional. Or you can have a colleague, friend or family member
actually make the trades for you. That way your emotions won’t stop you
from following the discipline. You’ll be able to go on vacation knowing
your system will be followed. Most important, you’ll be one step
removed from the emotional hurdles of getting in and out of the market.
Discover how professional money management can help you.
Get a Free Consultation from a Merriman financial advisor. |
|
