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4.3

Problems

Many measurements seem random, such as the heights of humans, the length of leaves, the roll of 5 dice, and the change of stock market prices. But when academics, statisticians and mathematicians view the world, they see patterns that others do not notice.

The device shown below on the left was first created by Francis Galton in about 1890 and today has many names; Probability Pinball, Galton Board, Quincunx Board, and Bean Machine. The Galton Board simulates random events and how the distribution of a large number of events tend to form a bell shaped curve. The beads falling through the pins are not predictable as to which course they will take, but the average outcome of a large number of dropping beads, just like 780 monthly returns of Index Portfolio 60, form a relatively predictable pattern. In 1794, Johann Carl Friedrich Gauss described the pattern as a normal distribution, referring the the fact that it is normal for random events to form such distributions. The more often an event occurs, the more a pattern emerges such as seen in the histogram of monthly returns for Index Portfolio 60. The beads randomly falling into different channels and the random monthly index price changes that are created due to investor's reactions to random news about capitalism, show essentially the same normal distribution.

Over the last 65 years, Index Portfolio 60 has an average return of 1.00% per month and a standard deviation of 3.13% and the pattern of the pins the beads flow through generate a distribution that looks quite similar. If the laws that provide for and regulate capitalism remain relatively constant, the risks will remain relatively constant and therefore the future monthly returns over a large sample of 20 years or more should emerge with similar distributions.

CLICK ON THE GALTON BOARD IMAGE BELOW TO VIEW ANIMATION

4.3.4

Gains and Losses are Impossible to Identify in Advance

Figures 4-3 through 4-15 shows the distribution of daily and monthly returns of the S&P 500 over several different time periods. The red bars indicate losses and the gold areas indicate gains. Note that the histograms is fairly evenly distributed (normal distribution) (or here), which is to be expected from a random distribution (see the Galton board.) Watch this video from the Khan Academy on the concept of the Normal Distribution.

The display of a central distribution around the average (Central Limit Theorem) is indicative of the randomness of the news that generates the random and unpredictable movements of the S&P 500 or any other index. Watch this video from the Khan Academy on the concept of Central Limit Theorem.

Based on the following histograms, investors can see how difficult it is to find the randomly distributed days with gains or to avoid the days with losses. For each period, the large gains or losses for the entire period are highly concentrated at the right and left tails, making them impossible to consistently identify them in advance. In other words, it is impossible for time pickers to consistently outperform the market.

 

Figure 4-3 (2010)

Figure 4-3 (2009)

Figure 4-4 (2008)

Figure 4-5

Figure 4-6

Figure 4-7

Figure 4-8

Figure 4-9

Figure 4-10

Figure 4-11

Figure 4-12

Figure 4-13

Figure 4-14

Figure 4-15

See the similarity of the distributions above to the 5 dice roll distribution on the right side of Figure 4-16 below. The characteristics of the average and standard deviation are not the same as the 964 monthly returns of the S&P 500 index, but the concept of a central distribution around the mean is very similar, as you see when they are compared. Also note the sampling error in the 5 year (60 month) periods as compared to the 964 months, which are very similar to the sampling error of only 60 roles of the dice, versus 1,000 rolls. The randomness of the news generates the random and unpredictable movements of the S&P 500. In a random distribution, successful market timing over the long term is impossible.

Figure 4-16

"A chance event is uninfluenced by the events which have gone before.  If a true die has not shown 6 for 30 throws, the probability of a 6 is still 1/6 on the 31st throw.  One wonders if this simple idea offends some human instinct, because it is not difficult to find gambling experts who... advocate ... the principle of 'stepping in when a corrective is due'." This is no different than stock market forecasters looking for the next "correction." Watch this video from the Khan Academy on the concept of the Law of Large Numbers vs Averages.

4.3.5

Time Pickers Lose

There seems to be universal agreement among investment experts that time picking is futile. Even so, it is not unusual for these same experts to actively tout its merits. Wall Street brokerage firms publish stock picking, time picking, money manager picking, and style picking studies to encourage existing and potential clients to change their investment strategies in midstream, which dumps more sales commissions into the pockets of these firms.

4.3.6

Time Pickers Pay More Taxes

Time pickers usually charge clients an annual fee of two to three percent of the value of their investment portfolios. These timers are nothing more than highly paid gamblers who bet with your money. Some investors who time markets invest in market timing mutual funds, which often produce high trading costs. The funds also generate short-term taxable capital gains due to the liquidation of fund stock positions to pay off departing shareholders. Investors can avoid cost-generating, tax-creating moves made by managers and shareholders of active mutual funds by remaining fully invested in index funds at all times. Especially mutual fund companies that restrict their shareholders to those who understand how the market works. Dimensional Fund Advisors is a firm that restricts access to their funds. Only large institutional investors and clients of pre-approved investment advisors are allowed to invest in the funds. You might call it a group of really smart investors.

In addition, when an investor moves in and out of investments, they create the possibility of paying a huge portion of their gains in taxes. For short-term gains, federal and state taxes can exceed 40% in some states. Even when time pickers are lucky enough to win, the taxes significantly reduce their return.

4.4

Solutions

The bottom line is this: the right time to be in the market is when an investor has money, and the right time to get out of the market is when an investor needs the money. The longer an investor can stay invested, the better. The investor who stays fully invested throughout the market swings experiences gains about two-thirds of the time. There is no reason to believe that professional market timers can correctly guess every two out of three favorable market periods over the long run.

Even though a buy-and-hold investor most likely experiences losses about one out of every three years over the long run, the losses of these fewer down years are far outweighed by the gains of the more numerous up years. Since 1926, the S&P 500 has averaged an excellent annual compound return of 10.7 percent with a range of plus or minus 20% two thirds of the time.

An investor who remains fully invested in down markets enjoys other advantages. The investor who remains in the market avoids exiting a down market, thus avoiding locking in losses on stock mutual fund shares. Hefty trading commissions or taxes on any realized capital gains are also deflected. An investor can also benefit by never again paying high market timing advisory fees.

Investors build real wealth only by maintaining a constant presence in the asset classes in which they are invested during the good times and the bad times. This not only gives long-term investors an immediate advantage each time the market goes back up after it has declined, it also allows them to participate in the market's climb in value over the long run. This makes them better stock pickers than the professionals who dart in and out of markets in unattainable attempts to anticipate where they will be heading in the future.

4.5

Summary

The goal of a time picker (also referred to as a market timer) is to obtain the upswings of the market and avoid the downswings. In other words, the goal is to get return without risk. Risk is the source of returns; therefore, investors must subject their capital to risk. It is only a question of how much risk is right for each investor.

Time picking is beneficial only to financial firms who make money trading shares and selling advice. The firms who charge top dollar for the best advice available in the world ironically end up with sub-market returns. Market strategists, even those considered successful have fallen away from the limelight. History has shown that market strategists, or any financial analysts for that matter, are right unless they are proven to be wrong. The industry has created a world in which complicated ratios and mathematical formulas are paraded in front of the public in hopes of impressing investors with superior knowledge and skills. This elevates the analysts in the public’s eye and ultimately influences investors’ decisions on which firm to choose to handle their investments.

The stock market has experienced a healthy upward climb in value over the long run, which is precisely what makes time picking so unnecessary. The best way for an investor to maximize advantage of these returns is to remain fully invested at all times, holding a globally diversified portfolio of index funds.

In Burton Malkiel's book, A Random Walk Down Wall Street, John C. Bogle is quoted as saying, "In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely not only not to add value to your investment program, but to be counterproductive."

In the end, time pickers have two critical decisions to make: when to get in the market and when to get out. The data is now conclusive that there is no reliable timing method to help with either decision. It is time, not timing, that determines an investor's return.

4.6

Review Questions

 

1. What percentage of accuracy must a time picker maintain in order to be successful?

a) 60 percent
b) 40 percent
c) 70 percent
d) 30 percent

2. Who was the only successful time picker ever recorded?

a) John C. Bogle
b) William F. Sharpe
c) There are hundreds of successful time pickers
d) There are no successful time pickers

3. The S&P 500 produced an annualized return of 17.5% in the 1980’s. A $10,000 investment that stayed fully invested throughout the entire decade grew to $50,162.00. What would the end value be if an investor had missed the best 40 trading days?

a) 12.6% return or $32,763
b) 9.3% return or $24,333
c) 6.5% return or $18,771
d) 3.9% return or $14,661

4. The best lesson to learn from market timing pundits is:

a) Time pickers have no way of predicting the market, and are therefore valueless
b) Be choosy when selecting time pickers, and research their records thoroughly
c) Companies do not report their earnings on a timely basis

We hope that after careful analysis of the data presented in this step, you are getting the message that trying to pick which time is the best time to be in the stock market is an absolute waste of your precious time. Instead of worrying about the market, do something you can control. Hug someone you love, pick some daisies, watch a sunset, and enjoy your life. It's a wonderful world, but it's often hard to see the forest through the trees.