Do we need to time the market?

Published: June 17, 2018 at 9:07 am

Last Updated on

For a while now, I have been wanting to do a full back-test of multiple market timing or tactical asset allocation strategies. I used a speaking invitation as an excuse to create a spreadsheet where multiple models can be quickly tested with 1000s of time periods.  While at it, I asked myself, do we need to time the market? I also recognised that question is different from, can we time the market?

The answer to, “can we time the market?” is a vehement yes, but we should recognise that market timing strategies have one common goal – reduce risk. So yes, we can time the market to reduce risk in portfolios. This risk reduction may or may not be associated with return enhancement. It all depends on the method chosen, the associated costs and tax.  Read more:

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In addition to these,   I have also analysed tactical “dip” buying.

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I am now building up to a series of tactical asset allocation back-tests with equity allocation swinging from 100% to 0%. And the results are pretty interesting. I am still thinking about how to present these results as they meant for the eyes of discerning DIY investors and can confuse newbie investors.

So I would like to first answer in this post: Do we need to time the market? Will I miss anything if I choose to avoid timing? The answer is: No, we do not need to time the market. No, we will not miss anything, BUT we need a proper strategy to systematically reduce risk in our portfolio.

This systematic risk reduction need not depend on any market signals. All we need is a clear goal. A clear date when we need the money and a clear target corpus. I had discussed this strategy in this post. Please read this in full as it will help you understand the context: How to reduce risk in an investment portfolio

Resolve is a series of steps on investing and portfolio management.  In the first step, we considered how to quickly select equity mutual funds and build a diversified (equity) portfolio. As a second step, we discussed how to quickly decide if I should stay invested in a mutual fund or exit it. Now, in the third step, we consider goal based risk management.

Let us consider a goal that is 15 years away. The current cost of that goal is 10 lakh. Assuming 10% yearly inflation, the future cost is shown below (blue dots). If we start investing for this in a mix of equity and debt (fixed income), the corpus assuming same returns (10% from equity and 7% from debt – both post-tax), the total corpus will be shown as below. The investment is assumed to increase by 5% each year.

RR 1 - How to reduce risk in an investment portfolio

Naturally, the aim should be for corpus (red line) to hit the target (blue line) on or before the end of the 15Y period. We start from 0, so it ends at 14. When the returns are fixed, you get a nice smooth corpus growth. Returns in real life fluctuate wildly as you will see below. This is known as sequence of returns.

Now, there are two way to invest in equity and debt. Use the same asset allocation for each year. Say 60% equity and 40% debt. We will refer to this as constant equity allocation

RR 2 - How to reduce risk in an investment portfolio

Or we can reduce equity gradually as we approach the goal. I prefer a step-wise decrease (on paper at least) and this is the approach recommended in the Freefincal Robo Advisory Software Template. We will refer to this as the reducing equity allocation.

RR 3 - How to reduce risk in an investment portfolio

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To these asset allocation strategies, we need real market returns. So I have used past Sensex annual returns.

To do this we take Sensex closing price. For the preliminary results shown here, I have used data from Jan 1991 to Jan 2018. This is the first return sequence considered

From Date To Date Return
01-07-1991 15 July 1992 121%
15-07-1992 15 July 1993 -26%
19-07-1993 19 July 1994 96%
21-07-1994 21 July 1995 -16%
25-07-1995 24 July 1996 1%
26-07-1996 28 July 1997 17%
30-07-1997 30 July 1998 -24%
03-08-1998 03 August 1999 45%
05-08-1999 04 August 2000 -9%
08-08-2000 08 August 2001 -24%
10-08-2001 12 August 2002 -9%
14-08-2002 14 August 2003 30%
19-08-2003 18 August 2004 26%
20-08-2004 22 August 2005 53%
24-08-2005 24 August 2006 51%

So we use: 121%, -26%, 96%, -16%, 1%, 17%, -24%, 45%, -9%, -24%, -9%, 30%, 26%, 53%, 51% as the sequence of annual returns for our portfolio.

Then we change the first date in the above table (marked in red) to the next business day to create the next sequence and so on. Here is another example:

From Date To Date Return
07-08-1991 06-08-1992 53%
06-08-1992 06-08-1993 -6%
10-08-1993 10-08-1994 83%
16-08-1994 16-08-1995 -24%
21-08-1995 20-08-1996 -4%
23-08-1996 26-08-1997 20%
27-08-1997 27-08-1998 -27%
31-08-1998 31-08-1999 67%
02-09-1999 04-09-2000 -3%
05-09-2000 05-09-2001 -30%
07-09-2001 09-09-2002 -3%
11-09-2002 11-09-2003 41%
15-09-2003 14-09-2004 29%
16-09-2004 16-09-2005 53%
20-09-2005 20-09-2006 42%

So we keep repeating this to create return sequences and this is the last sequence considered.

From Date To Date Return
22-11-2002 24-11-2003 53%
24-11-2003 23-11-2004 25%
29-11-2004 29-11-2005 45%
01-12-2005 01-12-2006 55%
05-12-2006 05-12-2007 42%
07-12-2007 08-12-2008 -54%
10-12-2008 10-12-2009 78%
14-12-2009 14-12-2010 16%
16-12-2010 16-12-2011 -22%
21-12-2011 20-12-2012 24%
24-12-2012 24-12-2013 9%
27-12-2013 29-12-2014 29%
31-12-2014 31-12-2015 -5%
04-01-2016 03-01-2017 4%
05-01-2017 05-01-2018 27%

This gives us a total of 2670 return sequences to test. In the above linked post, I had presented a few examples. For: -18%, -12%, 27%, -27%, 52%, -13%, -22%, -3%, 69%, 23%, 43%, 54%, 35%, -55%, 86%. Each of these is a return after one of year of investing. So 15 annual returns for 15 years of investing.

Constant Equity methodportfolio-risk-reduction method one

Decreasing Equity method

RR 7 - How to reduce risk in an investment portfolio

Now the question is, how do the results look if we backtest for all 2670 return sequences?

Constant Equity method (60% for all 15 years)

Total test runs: 2670

No of runs in which final portfolio value was equal to or above target value: 2670 (100%)

Decreasing Equity method (stepwise reduction)

Total test runs: 2670

No of runs in which final portfolio value was equal to or above target value: 2417 (91%)

No of runs in which final portfolio was equal to or above 90% of the target value: 2670 (100%). Full results will follow in a separate post.

Now, that is mighty impressive. Please note that the investment amount used for the decreasing equity method was the same as the constant equity method (the robo template accounts for this correctly). That is, it was lesser than necessary (when equity is fixed at 60% you need to invest less). So even then the result is remarkable.

So do you need to time the market? You can time the market if you wanted to, but there is no need. All you need to so is simple Goal Based Risk Managment to get you home.

UPDATE: Why we need to gradually pull out of equity investments well before we need the money!

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
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