William Bernstein2

IFA's Quote of the Week - 4 (William Bernstein)

William Bernstein2

Step 4 - Time Pickers"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, The Intelligent Asset Allocator



William Bernstein’s quote conveys two important messages. First, he articulates an investor’s inability to successfully profit from predicting the short-term future movements of the stock market. Second, and equally important, Bernstein sheds light on the parasitic industry that knows the randomness of short-term stock market movements, but profits wildly by preying upon the hopes and fears of investors. Cleverly crafted charts that describe double bottoms, resistance levels and breakout points, along with pseudo analytical reports alleging predictive profit patterns, all attempt to convince investors that frequent trading will help them avoid losses and earn big returns.

Wall Street’s motivation is abundantly clear. Recently, IFA estimated that the brokerage industry makes about $500,000,000 each day on the trading behaviors of active investors that costs them commissions, expenses and bid/ask spreads.  Let’s look at why all that activity is distracting and destructive to long-term expected returns.

To save you some time, all you need to understand about time picking is the Random Walk Theory. This theory simply states that nobody can consistently see what tomorrow will bring. Just remember that markets are moved by news--news that is unpredictable and unknowable in advance (that is the very definition of "news"). Because news is random and unpredictable, the markets move in a random and unpredictable fashion. Period, end of story.

This simple and easy to understand concept about the markets was first published over one hundred years ago. Virtually all subsequent academic studies detailing actual stock market data conclude that time picking is not likely to be a successful investment strategy.

From 1901 to 1990, the stock market return was approximately 9.5% per year. The SEI Corporation completed a study in 1992 that determined that in order to just equal this average annual return over the ninety-year period, a time picker needed to correctly select about seventy percent of the ups and downs of the market.

They also determined that if a picker called one hundred percent of the declining markets and only fifty percent of the rising markets, they still would fail to exceed the return of the overall market during this period. To add a final blow, there was no consideration for the higher short-term capital gains taxes or transaction costs involved in this highly flawed strategy. No wonder ninety-five percent of market timing newsletters go out of business.

More bad news for time pickers. First, most of the gain achieved in a rising market is often concentrated at its beginning in highly concentrated surges. Because the markets go up on average, there are greater benefits to be in the rising markets than there are to avoid the falling markets. These additional tidbits were some of the conclusions of a New York University study completed in 1986. The clincher was that the academics found no evidence that time pickers could successfully time either the beginning of a rising market or the end of a falling market.

The Table below shows the benefits of buy-and-hold investing as opposed to the lunacy of time picking. This study examined the 2,516 stock market trading days for the ten-year period from 1997 to 2006. The data shows that during this period, the S&P 500 produced an annualized return of 8.4%. A smart and prudent investor who invested $10,000 in the S&P 500 at the beginning of 1997 and stayed fully invested was handsomely rewarded with a $12,444 gain by the end of 2006.

However, if just ten trading days with the largest gains were missed, the annualized return would have dropped from 8.4% to 3.4%. Instead of gaining by $12,444, the investor would have ended up with only a $3,992 gain. If the best 20 trading days were missed, which is less than 1% of the total number of trading days, the annualized return would have dropped to a minus 0.4%, yielding a loss of $360. Thus, more than 100% of the return would have been lost in just 20 days, or an average of two days per year. The random walk of any of the world's markets are impossible to predict.

To better visualize just how hard it is to find those 20 days, here is an image of the whole period in the study.

Another study from cypen.com found that being fully invested in the S&P 500 for the five-year period ended December 31, 1995 yielded a 16.5% average annual total return. If a market timer missed the twenty best days, that return fell to 7.3%. And if the sixty best days were missed (that's only twelve days per year), the return plummeted to -3.4%.

The odds against success in picking the right times are overwhelming, and the odds become worse over time with the high taxes and costs associated with frequent trading. So, in order to avoid the transfer of your wealth to Wall Street brokers, buy and hold a passively managed, risk-appropriate, globally diversified index portfolio and forget trying to predict short-term movements because the long-term picture looks promising for buy and hold investors.