William Bernstein

"There are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know. Then again, there is a third type of investor - the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know."

— William Bernstein, 2001

Charles Ellis

"Market timing is a wicked idea. Don't try it — ever."

— Charles Ellis, Winning the Loser's Game, 2002

Benjamin Graham

"If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what`s going to happen to the stock market."

— Benjamin Graham, Interview with Hartman L. Butler, "An Hour with Mr. Graham", March 1976

Zvi Bodie

"Statistical research has shown that, to a close approximation, stock prices seem to follow a random walk with no discernible predictable patterns that investors can exploit. Such findings are now taken to be evidence of market efficiency... Only new information will move stock prices..."

— Zvi Bodie, Investments, 2004

Introduction

Fortune Teller
Fortune Teller

P.T. Barnum is often credited with coining the phrase, "There's a sucker born every minute." History buffs argue the famed circus founder instead stated, "There's a customer born every minute." However, for investors subscribing to market-timing services, the words "sucker" and "customer" are virtually interchangeable.

Time Pickers or market timers claim the ability to predict the future movement of the stock market, moving into the market before it goes up and getting out before it goes down. However, numerous studies from industry and academic experts demonstrate market timers have no such ability to beat the market, and they should be avoided just like the lion's cage at Barnum's circus. According to Eugene Fama, "Market timing is a flimsy, dangerous occupation."1

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Gurus are Inaccurate Too Often

How often does a market-timing guru need to be right to beat an index? Nobel Laureate William Sharpe set out to answer that very question in his 1975 study titled, "Likely Gains from Market Timing."2

Sharpe wanted to identify the percentage of time a market timer would need to be correct to break even relative to a benchmark portfolio. He concluded a market timer must be correct 74% of the time in order to outperform a passive portfolio at a comparable level of risk. In 1992, SEI Corporation updated Sharpe's study to include the average 9.4% stock market return from the period 1901-1990. This study determined that gurus must be right at least 69% and as high as 91% of the time, depending on the timing of the moves.3

What percentage of times do market timing gurus get it right? CXO Advisory Group tracks public forecasts of self-proclaimed market-timing gurus and rates their accuracy by assigning grades as "correct," "incorrect" or "indecisive." Figure 4-1 depicts CXO's percentage grades for 34 well-known market-timing gurus who made a collective 3,541 forecasts from 2000 - 2012.4 The study shows that not one of the self-proclaimed gurus was able to meet Sharpe's requirement of 74% accuracy, or SEI's minimum 69%, thereby failing to deliver accuracy sufficient to beat a simple index portfolio.

Figure 4-1

At first glance, the 12 gurus who had percentage accuracy of more than 50% might look appealing to a time picker—but beware, the opportunity costs associated with a time picker's proclivity toward holding cash in some up years creates a higher hurdle as they will have to make up those higher returns foregone by stocks. Transaction costs associated with market timing add another hurdle for market timers to break even.

In The Big Investment Lie,5 Michael Edesess explains why market timing is so difficult, "The stock market can turn on a dime and always does. Prices are constantly twisting and turning without trend or predictable pattern. Their recent movement gives you nothing to go on."

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Studies Prove Time Picking Doesn't Work

A study by University of Utah Professor John Graham and Duke University Professor Campbell Harvey is titled, "Market Timing Ability and Volatility Implied in Investment Newsletters' Asset Allocation Recommendations."6 The massive 51-page study tracked 15,000 predictions made by 237 market-timing newsletters from June 1980 to December 1992. By the end of the period, 94.5% of the timing newsletters had gone out of business with an average life span of just four years. "There is no evidence that newsletters can time the market," the study concluded. "Consistent with mutual fund studies, ‘winners' rarely win again and ‘losers' often lose again."

"Sure, it'd be great to get out of stocks at the high and jump back in at the low," observed John Bogle in an April 2008 interview with Money7 Magazine. "[But] in 55 years in the business, I not only have never met anybody who knew how to do it, I've never met anybody who had met anybody who knew how to do it."

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Missing the Best and Worst Days

Almost all big stock market gains and drops are concentrated in just a few trading days each year. Missing only a few days can have a dramatic impact on returns. Figure 4-2 illustrates how an investor who hypothetically remained invested in the S&P 500 Index throughout the 20-year period shown (5,037 trading days) would have earned a sizable 9.22% annualized return, growing a $10,000 investment to $58,352. When the five best-performing days in that time period were missed, the annualized return shrank to 7.00%, with $10,000 growing to $38,710, and if an investor missed the 20 days with the largest gains, the returns were cut down to just 3.02%. If the 40 best performing days were missed, an investment in the S&P 500 turned negative, with $10,000 eroding in value to just $8,149, a loss of $1,851.

Figure 4-2

Many market timers want to miss the worst-performing days, an even bigger issue than the problem of missing the best days. The predicament, however, is that the worst days are equally concentrated and just as difficult to identify in advance as the best days. If someone could have avoided the worst days, they would have obtained true guru status. Figure 4-3 illustrates the value of missing the worst-performing days in the 20-year period shown. If the 40 worst-performing days of the S&P 500 Index were missed, an investor’s increased return would have been 893% more than investors who stayed in the market every day throughout the entire 20 years. The problem, however, is finding the crystal ball that can forecast the 40 worst performing days out of 5,037 days. This shows how market timing can be tempting and alluring.

Figure 4-3

University of Michigan Professor H. Nejat Seyhun analyzed 7,802 trading days for the 31 years from 1963 to 1993 and concluded that just 90 days generated 95% of all the years' market gains—an average of just three days per year8.

The expected return of the market is essentially constant and positive. Therefore, investors who are out of the market for any period of time can expect to lose money relative to a simple and low-cost buy-and-hold strategy.

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Goddess Fortuna

Goddess Fortuna
Goddess Fortuna

Many investors believe market watchers and financial journalists have a special ability to forecast future movements of markets, but history tells a different story. Take the first half of 2009, when market forecasters largely dismissed the rise in stock prices that began in mid-March 2009 as an aberration that would soon be rectified. Only market timers who had the Goddess Fortuna, also known as Lady Luck, whispering in their ears might have predicted that outcome.

The Goddess Fortuna offers a cornucopia of gold coins and delicious treats, but she is sitting on a bubble that floats in the ocean, reminding us how fleeting luck can be. Also, her flowing scarf reminds worshipers that their fortune can change like the wind.

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News is Devoured in Minutes

Devouring the News
Devouring the News

In Analysis for Financial Management,9 Robert C. Higgins portrays how market participants instantly devour new information, which serves as the inspiration for the painting on the following pages. "The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranhas," Higgins writes. "The instant the lamb chop hits the water there is turmoil as the piranhas devour the meat. Very soon, the meat is gone, leaving only the worthless bone behind, and the water returns to normal… no amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."

A 1969 study titled, "The Adjustment of Stock Prices to New Information,"10 was conducted by Eugene F. Fama, Lawrence Fisher, Michael Jensen, and Professor Richard Roll at the University of California, Los Angeles. The study concluded it takes five to sixty minutes for market prices to completely reflect new information. Fund managers try to exploit whatever slight gain might be had by reacting quickly to a news story, but the likelihood of them consistently being on the right side of a trade in reaction to the news is extremely low.

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Going or Gone?

When discussing the direction of the market, it's important to use the past-tense verb. During times of high market volatility, people commonly make the mistake of saying, "The market is going down (or up)." Although it appears harmless, this statement implies that the direction of market prices is knowable. People making this statement often use it as the impetus for major investment decisions. Such decisions usually do not fare well, because they are based on the fallacy that one can predict the direction of future price movements. Investors can avoid this pitfall by understanding Eugene Fama's finding that security prices move in a random walk. At any point in time, we only know the current and past price of any given security. Where the price will be even a second later is unknown. The market continuously sets prices in response to news, which by its very nature is unpredictable. Investors will accomplish an important step when they can say, "the market has gone down (or up)" without even having to think about it.

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Free Market Forces

Market Forces
Market Forces

The job of free markets is to set prices so that investors are rewarded for the risks they take. To help explain this important statement, I created the Hebner Model, which attempts to simplify market forces into three variables: Price, Expected Return and Uncertainty. Prices move in the opposite direction of economic uncertainty so that expected returns at a specified level of risk can remain essentially constant, resulting in a fair price. From fair prices we expect fair returns, meaning that investors should be compensated for their risk exposure over time.

The reason people invest is to get a return. At the time of a trade, buyers pay a price that reflects the risk associated with capturing the expected return. In other words, a fair price equals a fair expected return.

This model is based on Eugene Fama's Efficient Market Hypothesis, which states that prices fully reflect all available information or news, economic uncertainty and probabilities of future events, thus implying that market prices are fair.

The Hebner Model illustrated in the "Market Forces" painting attempts to diagram the three variables of Uncertainty, Expected Return and Price, resulting in a distribution of returns shown at the bottom. The diagram shows the essentially constant expected return for a given investment portfolio. In this case Index Portfolio 50 is shown at the fulcrum of the teeter-totter, and the period-specific expected return can be estimated based on 30, 50 or 85 years of simulated returns, the Fama/French Three or Five-Factor Model, or any methods an investor chooses. Current news impacts uncertainty and is represented on the left side of the teeter-totter. This economic uncertainty includes the probabilities of future events. The price agreed upon by willing buyers and sellers is on the right side. When an investment's price has fallen by 2%, one could infer that uncertainty has increased by about 2%. Alternatively, when the price has increased by 2%, without knowing the news, one could deduce that uncertainty has decreased by 2%. In other words, prices react to shifts in uncertainty so that expected returns remain essentially the same.

From a fair price investors should expect: 1) a fair outcome, which would be a risk-appropriate or fair return; 2) an equal chance of being greater than or less than that fair return; and 3) the farther the actual return is from the expected return, the lower the probability of its occurrence.

So before you trade, ask yourself: 1) Who is on the other side of my trade? 2) Do I think I know more than they do? 3) Am I paying a fair price? In my opinion, your answers are as follows: 1) You don't know; 2) It's highly unlikely; and 3) If there are many willing buyers and sellers, by definition, it is a fair price.

For these reasons, market timing offers no advantage. Time pickers cannot forecast the direction of the market. There is no competitive edge that exists. The best way to earn the market's return is to simply remain invested at all times in a lower-cost, passively managed index portfolio.

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Footnotes:
  • 1Eugene Fama, Dimensional Financial Advisor Conference, Santa Monica, CA, July 22, 2011.
  • 2William Sharpe, "Likely Gains from Market Timing," Financial Analysts Journal, vol. 31, no. 2 (1975).
  • 3"Technical Note: Calculation of Forecasting Accuracy", SEI Corporation position paper, April 1992.
  • 4Forecast Accuracy Chart
  • 5Michael Edesess, The Big Investment Lie: What Your Financial Advisor Doesn't Want You to Know (San Francisco: Berrett-Koehler Publishers, Inc., 2007).
  • 6John Graham and Campbell Harvey, "Market Timing Ability and Volatility Implied in Investment Newsletters' Asset Allocation Recommendations," Journal of Financial Economics, vol. 42, no. 3 (1996).
  • 7"Calming Words for Troubled Times," money.cnn.com, last modified April 28, 2008, http://money.cnn.com/galleries/2008/pf/0804/gallery.expert_opinions.moneymag/12.html.
  • 8H. Nejat Seyhun, University of Michigan, "Stock Market Extremes and Portfolio Performance," commissioned by Towneley Capital Management, 1994
  • 9Robert C. Higgins, Analysis for Financial Management (New York: McGraw-Hill/Irwin, 2004).
  • 10Eugene F. Fama, Lawrence Fisher, Michael Jensen, and Richard Roll, "The Adjustment of Stock Prices to New Information," International Economic Review, vol. 10, no. 1 (1969).
step 4time pickersmarket timingeugene famawilliam sharpecxo advisory groupthe big investment liemichael edesessjohn grahammarket-timing newslettersjohn boglemoney magazinefisher blackh. nejat seyhungoddess fortunalucklady luckrobert c. higginseugene f. famalawrence fishermichael jensenrichard rollhebner modelfive factor modelthree factor model

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