Market "Timing" Means Risk Management - And It Does Work

Many investor advisors and investors believe that timing the market is not possible, and in fact is a fool's game because long-term returns suffer as a result of trying.  The critics talk about too much trading leading to transaction costs and taxes that can only be avoided with a BUY and HOLD strategy.  Also, the critics point towards the fact that much of the performance in a BUY and Hold strategy comes from very few small periods where investors often get out before the run but don't get back in until much of the performance has past.  The great Value Expectations blog has this to say about the subject:

Market timing is the practice of many investors to try to predict the best time to buy and sell stocks based on expected market direction. For example, a mutual fund manager might switch a portion of his fund's holdings from stocks into cash when he believes that the market has peaked. If he times the market correctly, he could make a huge profit. Then, when he thinks the stock market is significantly undervalued, he could shift back into stocks in an effort to make another hefty gain. If such an investor was able to successfully time the market since 1950 till today and avoided the 20 worst performing months for the period, he would outperform an invested at all times strategy by 458 basis points annually.
 

Missing the worst months, yields more incremental performance than missing the best months since 1950.  This is why we consider this a "risk" management process, not just something called a market timing process.

We have developed a business model and an investment process which takes care of two of the main objections of the BUY and Hold crowd. First, the cost of transactions is relatively small in our institutional world.  In fact, we use a new technology so that our separately managed accounts at Rapidan Capital's service called Berk Advisory can trade frequently with NO COMMISSIONS.  That's right it cost NOTHING per transaction for most stocks when we trade, re-balance or otherwise "time" our purchases and sales.  There is simply one flat fee of about $300 per year!.

Second, in our private hedge funds we have always maximized AFTER-TAX returns so we deliver as little realized gains as possible through the best tax deferral scheme known to US investors - and that is BUY stocks of Great Companies and let them ride through time.  Sometimes, however, we have to sell those stocks when the market's greed pushes prices to excessive levels.  Remember we want to maximize after-tax return - the goal is not to pay any taxes, but we know that that can't be done at the same time we are trying to maximiz after-tax return. We do not want the tax tail wagging the life-time return dog. 

That strategy creates too much risk and ignores changing competitive circumstances and prudent portfolio mamanagement using correct risk adjusted position sizes.  Therefore, our professional process avoids the pitfalls of market timing - too much trading and too much in transaction costs - by using technology to avoid per transaction costs and by using tax management strategies like harvesting losses to offset against any gains, while maximizing economic returns.

The folks at Value Expectations do a good job of explaining why for most independent investors and financial advisors market timing does not usually work and they ought to just settle for the median return of 7% per year over time.  Humans are subject to irrational emotional reactions that are predictable.  Investors and advisors and even professional mutual fund managers are people and it has be shown that people hate losses by 2.5x more than we like gains.  Thus, when we finally make the decision to get out because of losses, we certainly ease our mental pain, and it takes a lot more discomfort for us to get back in the market.  Therefore, we inevitably get in too late by waiting to get back in the market .  Of course, by that time the stock market has gone up and we missed some those best months.  The conclusion for most do-it-yourself investors, then, is to BUY and Hold.

Behavioral issues: A huge number of investors believe they follow a certain value strategy, while in reality they are subject to irrational emotional reactions to market fluctuations, which prevent them from perfectly timing the market. Often times such investors would wait on the sidelines for too long when the market is increasing, and jump in only after they can no longer watch other investors profiting from the run. When the market is in decline, on the other hand, this irrational system prompts the investors to remain invested for too long, even as they continue to lose money, eventually selling at very depressed prices. If our investor was unable to pperfectly time the market and missed the 20 best performing months instead, that would translate into 331 basis points annual underperformance relative to an invested at all times strategy.

We do not fully agree.  Notice how much more money you are left with over the period if you avoid risky markets.  The graph above shows that avoiding the worst months (green line) yields $589,000 versus about $50,000 for the BUY and HOLD strategy - our process is designed to capture much of that difference.

BERK

We think we have a process that allows us to own the shares of the Best Companies who are growing long-term value (EVA) in the correct position sizes. But we also monitor the trend of the market and adjust our exposure according to the measured risk in the market...The difference is that we use an unemotional instrument panel that gives us a high probability of understanding how much money we ought to have at risk in total.

This wholly rational, data driven process allows us to avoid the pitfalls that many investors succumb to.

BERK 

Comments

[James Fowlkes]

Fantastic article, will tweet this one out right away!