Is it better to trade the market instead of investing in it for the long term? What is timing the market?

Timing means trying to anticipate the market direction through shifts between stocks and cash/bonds. With market timing, the focus is on the direction of the overall market. The focus with investing is on the merits of the individual businesses. Investing in the market means buying parts of different businesses.

Over the last 85 years, the S&P has generated positive returns approximately 75% of the time. So, by trying to time markets you try to avoid the 25% of the time the markets decline. The problem that market timers face is how to identify when these down markets occur. Many different measures of market valuation have been developed. Unfortunately, none of them have been able to consistently generate accurate buy and sell signals.

The academic research in this area supports the view that market timing does not add any value. Below, we summarize some of the research that has been done in this area:

    * Morningstar, the mutual fund newsletter company, identified market-timing funds that have been around for more than five years. These funds have produced only 80% of the average return of all diversified U.S. stock funds over comparable periods.

    * Hulbert Financial Digest, which ranks other financial newsletters, has similarly found that market-timing funds have produced 80% of the return on the Wilshire 5000 stock index over a recent five-year period.

    * An unpublished study of 100 large pension plans found that all the funds had experimented with market timing. Not one improved its rate of return as a result of timing. Moreover, 89 of the 100 experienced a loss averaging 4.5% per year over the five years studied.

    * All studies we have reviewed confirm that due to the large number of transactions, the after tax, after commission performance of market timing funds lags diversified index funds by an even greater margin.

Robert Reich, the former economic advisor to the Clinton administration, often tells our favourite story about market timing. He recounts how he was on television just before the 1987 market crash. He told the television audience that they should sell everything and move to cash. After the crash, he was inundated by hundreds of phone calls and letters asking to subscribe to his market letter. The joke is that he had been making the same call since 1982!

How likely is it that a given market timer will consistently produce returns?

With the universe of investment managers larger than the number of Taco Bells in the United States, it is not surprising that some manage to outperform the index over a one-year period. Was their performance due to luck or skill? The top performing manager will certainly argue that the results are due to skill; however, with such a large pool of managers luck can not be easily dismissed. In fact, the top performing manager in any particular year is rarely able to accomplish the same feat in a subsequent year.

If market timing doesn’t work, why do so many people try it? The answer lies in human behavior. Consider an experiment in which you outfit a room with two lights, one red and one green. (Think of the green light representing the S&P 500 index moving up and the red light representing the S&P moving down) The lights are set to blink randomly, although the green light will flash 73% of the time while the red light will only flash 27% of the time (the S&P has provided positive total returns 51 of the last 81 years or 73% of the time). A monkey will be rewarded with food every time it correctly picks which light will flash next. After a number of tries, the monkey will guess green every time, and will be rewarded with food 73% of the time. Monkeys know better than to time the “food market”. In fact most animals will do the same.

Here is where people differ from animals. Asked to perform the same experiment the human will instead try to guess the pattern of light flashes even if the person is told that the light flashes are random. Unfortunately, by guessing in this way, the person will only be right 61% of the time.

Where does the 61% figure come from? If you are mathematically inclined, 73% of the time the subject will guess green and the light will, in fact be green 73% of the time, while 27% of the time the guess will be red and it will be red 27% of the time, resulting in a successful percentage of 0.73 x 0.73 + 0.27 x 0.27 = .606, or approximately 61%.

So what does this all mean? Assume you had $100 to invest in the S&P 500 in 1920. Here is how your investment would have performed:

* Had you resisted the urge to market time (like a good monkey) $463,000
* Had you timed the market with a 61% success rate (the average investor) $145,000

As you can see, the difference in results is dramatic. If we look instead at 20 year rolling averages, we find that the average market timing investor (with a 61% success rate), would only have outperformed the market over 12 of the 63-20 year periods between 1920 and 2000 (a success rate of 19%).

In order to have beaten the market during the 1919 to 2000 period, an investor would need to have made the right call 71% of the time - a tall order for even the smartest monkey!

In summary, market timing is a losing proposition. For investors this means resisting the urge to sell stocks and buy bonds during any period of uncertainty. The odds are that you will not be able to identify when it is time to get back in.