What it is
Market timing isn’t following the business cycle by rotating a portfolio to make it more aggressive or more defensive as economic conditions change. It’s not selling a stock when you perceive it to be overvalued and replacing it with something else. It’s also not using limit orders to buy or sell at more favorable prices.
It is the attempt to gain performance by raising large amounts of cash when the market is at a top and reinvesting it at a subsequent low.
Timing the market vs. time in the market: the conventional case against timing
The cliché is that equity investing is not about timing the market, but about time in the market.
1. The penalty for timing mistakes can be huge
The evidence advanced in support of this position consists in relatively straight-forward academic and brokerage house studies that demonstrating if you are absent from the stock market for only a handful of the best-performing days for the S&P 500, your returns fall off dramatically. The link to one from Fidelity is here.
What’s particularly striking about the Fidelity report is that missing the best 10 days out of about 7,000 over 28 years (about .15% of the possible trading days) would reduce your return for the period by over 40%.
(Remember, too, that the absolute returns are a function not only of time but also of the starting and ending points. In the Fidelity case, the measurement begins during the second oil shock and after a several year-long flat period for the S&P. It ends near a market high. Therefore, absolute returns are big. In contrast, recent news reports are emphasizing that market returns over the past ten years have been close to zero. I haven;t seen any that point out that the starting point is near the peak of the internet bubble and the end point is close to the bottom of the worst bear market since WWII.)
2. Individual investors are awful timers
That’s not all the bad news about market timing. Individuals in the aggregate have terrible instincts about timing. In fact, individual investors are an excellent contrary indicator. That is, they tend to push money into the market at peaks and then remove it at lows.
In addition, studying the speed bumps the market continually goes over can take a lot of time and energy–that I think would be better spent in fundamental company research. Also, frequent trading may mean a higher payments to the IRS, if the trading is done in a taxable account.
Why then are timing indicators so readily available on broker websites? They’re easy to generate by computer, the raw data don’t carry the legal liability risks that company research reports do–and, of course, trading generates commission revenue for brokers.
All this is pretty well-known and accepted in the investment community. But, bad as the situation sounds, the conventional wisdom doesn’t convey what I think is the most damning argument agains market timing.
What I think the biggest timing difficulty is
To be successful, a market timer has to be able to do two things: he has to be able to sell high, and then he has to reinvest the cash in the market at a low point (that is, buy low).
In close to thirty years as a professional investor, I’ve had many colleagues or associates who could do one or the other. But I’ve never worked with, met, seen, or for that matter heard of (you get the idea), anyone who could do both.
Granted, most professionals don’t try market timing. Contracts with institutional customers will likely prohibit it. And since the manager risks his firm’s reputation as well as his own, large organizations won’t allow it either.
How timing problems develop
In my experience, problems always develop from the decision to sell. One of two things happens to market timers:
1. the timing conclusion is wrong. The manager decides that the market is at a high point, sells 50% of his portfolio and the market is 10% higher three months later. The manager now faces a real dilemma. He’s lost 500 basis points to the market in the blink of an eye. He know it could take him several years to recover that performance through stock picking. He also doesn’t want to admit he’s wrong and cut his losses (he also secretly worries that the minute he capitulates and reverses hid bet, the market will drop like a stone–making him look like a complete idiot). So he’s stuck. He’s in an emotional turmoil and thinks his only choice is to tough it out until the market turns. So he compounds his original mistake.
2. the timing conclusion is right. The market is at a high point and begins to drop soon after the manager sells. Invariably, the manager enjoys his new notoriety. The more the market falls, the more bearish the manager becomes. His success reinforces his negative bias. He always misses the turn back up (as I mentioned above, I’ve never seen any seller of this type get the reinvestment timing right). A less pernicious, but still psychologically powerful, dilemma now confronts the successful seller.
By raising large amounts of cash right in advance of a market drop, he has gained, say 700 basis points of outperformance. But the market has since recovered half its fall, meaning that about half the outperformance has been erased. What to do? The obvious choice is to return to a neutral position and preserve the remaining outperformance. But invariably, the manager continues to read the upward movement as a counter-ternd rally in a continuing down market. And he’s psychologically loathe to have taken the large risk of raising cash, in return for the now diminished reward. So he tells himself that he’ll reinvest his cash when the market returns to the old low–which, of course never happens.