Why do people time the market? That is, why do they enter and exit the market based on certain signals (moving averages, PE etc.)? Is it for getting better returns? Or is it for getting risk adjusted returns?
This is a poll I created in Facebook group Asan Ideas for Wealth. As expected, a majority of members believed that timing the market is for getting better returns.
In this post, I would like to answer this question with a digest of a research paper. I am not interested in individual investor experiences either in the US market or in the much younger Indian markets. Relying on those, in my insignificant opinion, is not the ‘scientific’ way to answer the titular questions. I am only interested in studies backed by academic rigour. If you don’t agree, so be it. I can live with that.
I will not consider back-testing results from Indian market history. It is too short to be statistically significant. If you argue, that the Indian market is different from the US market, I can argue, ‘then why is it all trading metrics are derived from backtesting studies of the US market!’.
The academic community is divided in its answer. For every report that says ‘one can time the market’, I can give you a report that says ‘one cannot time the market’.
Naturally AMCs and mutual fund sales are expected to say, stick to you SIPs and do not time. Needless to say, such opinions can rejected straightaway.
It is important for the reader to understand that, even those papers which say ‘timing works’, only refer to superior risk adjusted return with market timing. Not superior return.
Risk adjusted return is a ratio – return per unit risk and is not the same as return. Crudely, price to earnings (PE) is analogous to risk-adjusted return which is distinctly different from the (stock/index) price.Read more: What is a risk-adjusted return
The most popular timing model paper is by M. T. Faber, “A Quantitative Approach to Tactical Asset Allocation”, Journal of Wealth Management, 9 (4), 69–79. (You can download this paper via above link). Ramesh Mangal tells me that this is is one of the most-downloaded papers from the SSRN network.
Faber uses a 10-month simple moving average (SMA) to time the market. This, for example is one of the simplest strategies he has used.
Monthly price > 10-month SMA –> Buy
Monthly price < 10-month SMA –> Sell and move to cash
When I read his paper, the most striking result was on page 28:
Appendix B breaks down the returns down by decade for the S&P 500 and the timing model. While the timing model outperforms in about half of all decades on an absolute basis, it improves risk-adjusted returns in about two-thirds of all decades and improves drawdown in all but two decades
The timing model improved return for only half the decades from the 1900s. This means, buying-and-holding outperformed the timing model in some decades and vice versa in other decades.
If I start to time the model today, I have no idea whether my strategy will fetch more returns (a common expectation) in the next 10 years. The chances are 50-50, if we go by past performance. As seen in yesterday’s post, “Will long-term equity investing always be successful?“, market dynamics are bound to change with time and past performance is unreliable in more ways than one.
Therefore, my key takeaway from Faber’s paper is, Market timing depends on how the stock market fares in the future (bull/bear/sideways). Since I do not know how it will fare in the future, success is down to luck.
I was looking for a research work to back my thinking. When Prashanth Krishna who runs portfolio yoga tweeted about a new paper on market timing: Revisiting the Profitability of Market Timing with Moving Averages.
When I corresponded with the author of the above paper, Prof. Valeriy Zakamulin, School of Business and Law, University of Agder, Norway, he cited his other work on market timing: A Comprehensive Look at the Empirical Performance of Moving Average Trading Strategies and sent me the original figures for this post!
They considered multiple market timing strategies like simple moving average, exponential moving average, double moving average (like the hurricane warning chart in the Nifty Valuation Analyzer) using the S&P 500 from Jan 1860 to Dec 2014 (155 years, 1860 months!). They divided the data set into two using statistical means.
Their main conclusions are listed below:
1. There is strong evidence that the stock market dynamics are changing over time.
In the second half of the data set (panel B) the stock market was less volatile, the stock prices grew with a rate that was more than double as much as that over the first half, and the ratio of the average Bull market length to the average Bear market length was almost double as much as that over the first half.
2. Moving average strategies outperformed the market in the first period (panel A).There is no statistically significant evidence of outperformance in the second period (panel B)
Thereby our findings cast doubts that market timing strategies can consistently beat the market.
3. There is optimal moving average duration. For example,many think that the 200-day DMA is the ‘best’ to use. This cannot be justified.
4. “The outperformance delivered by market timing strategies is highly uneven over time. Most of the outperformance is generated mainly over relatively few particular historical episodes” Results depend crucially on the sample period chosen. Which is why many authors argue in favour of timing.
If one chooses the sample period to be, for instance, either 1900-2010, 1970-2010, or 1990-2010, and simulates, for example, the SMA(10 month) strategy, then one comes to conclusion that market timing works
If the sample period chosen is 25 years after 1970, then market timing fails. If the sample period is post 2000 then market timing wins. The point is, market timing works …sometimes. Since we do not know how the market will fare in future, is it impossible to claim market timing will work for my investment strategy!
If you have reached up to this point, thank you for your patience. There is no statistically rigorous evidence that market timing will work. If wish to enter and exit following the PE or moving averages, I strongly suggest you keep better risk adjusted portfolio return and (temporary) capital protection as the goal and not ‘higher returns’.
I am not recommending to time the market. Personally I will not time the market because it does not suit my temperament and I have better things to do.
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
- We are also on Google PlusandPinterest
Do check out my books
Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You WantMy second book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a youngearner
The ultimate guide to travel by Pranav SuryaThis is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for ₹199 (instant download)
Free Apps for your Android PhoneAll calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)