Selecting a long term investment plan and maintaining it over time is the key to investment success.
However, market conditions that are constantly changing can make this difficult to do. The current stock market environment, where daily movements of 100-200 points in the DOW are the norm, can tempt investors to deviate from their established investment plan by sharply reducing their equity exposure, or by staying in cash. These investors are engaging in market timing, although they may not even realize they are doing so.
Trying to Time the Market
At first glance, market timing can appear to be a viable investment strategy. In fact, accurate market timers could generate returns in excess of those available to adherents of a more consistent investment strategy, IF they could do it consistently over time.
However, if the investor did measure their portfolio performance against a market benchmark, they would probably find that over time their portfolio had performed relatively poorly. That is because, while market timing is a concept that sounds good in theory, it is nearly impossible to execute in the real world. “Trying to predict (the market’s) direction over the near term is an exercise in futility.” These words were spoken by the legendary mutual fund manager Peter Lynch, one of the most successful investors of all time.
The Difficulty of Market Forecasting
When it comes to investing, successfully forecasting when the market will go up or down,should result in superior long term investment returns. However, in order to be successful, the prognosticator must not only correctly determine the direction of market movements, but also their magnitude and timing. The majority of academic studies, as well as many market participants, agree that doing this on a consistent basis is virtually impossible.
To make matters even worse, successful market timing requires the prognosticator to correctly forecast the market, not once, but twice. A market timer must successfully predict a market movement, which prompts them to deviate from their established investment strategy in an attempt to capture additional returns. Then, the market timer must make another correct prediction in order to decide when to return to their chosen long term investment strategy.
If the odds of correctly timing a market movement are 50/50, then the chances of correctly entering and reversing a market timing trade are 25%. The chances of correctly executing two market timing trades are 6 in 100, the and the odds are only 1 in 1000 that a market prognosticator will be able to correctly time their entry and exit from market on five separate occasions (this is a failure rate of 99.9%).
While some market timers might argue that their odds on any given trade are greater then 50/50, many studies indicate that this is unlikely to be the case.
In fact, academic surveys that measure the predictions of many of Wall Street’s leading economists and market strategists indicate that their actual success rate at predicting interest rate movements is less than 50%. In other words, some of the world’s most successful economists are less accurate than a coin flip.
Last year was the perfect case for illustrating the futility of trying to predict the market. The consensus of the so called “experts” was that the market would rise 10-15%. What happened during 2011? The S&P was flat for the year. There was almost a unanimous consensus that interest rates had to rise, and that investors should shorten their maturities. What happened: There was a huge bond market rally, and long term US Treasuries returned 28%.
Investor Returns and Market Timing.
Long term, although the S&P has averaged 8% annual returns over the past 20 years, ending in 2010, only over a hand full of these years, did the market have a return of around 8%. Most of the time the market returned a lot more or less than 8%, but averaged out to 8% over time. Once again, missing out on the best annual returns would significantly lower your long term return.
A recent study by Dalbar Inc., a firm that conducts market research, found that the average investor, over this time period, only earned about 3% in equities, not the 8% long term annual rate of return of the S&P.
Why? The average investor tries to time the market, but ends up buying high and selling low and staying invested, on average, only 2-3 years at a time.
The most recent market decline, was a case in point. At the lows, March, 2009, many investors became frightened and bailed out of the market, as there were record redemptions in equity mutual funds during this period. Now for the good news: From March, 2009- February, 2010 the S&P was up 53%. By early 2011, the market recovered almost 100% of the losses of 2008-2009. Had you panicked and jumped out of the market after the crash, you would have missed a huge market upturn.
Everyone wants to be in the market when it goes up and out when it goes down. That is called “Market Timing.” However, ALL academic studies have shown that it cannot be done.
“Name the ten most successful market timers of all time. How about the top five? The top one?
Until someone can name at least a few successful long term market timers, I remain a skeptic
and will continue to “bet” on some form of diversification together with a long term plan.
Finding Long-Term Success
In order to enjoy long term success, an investor must have a process that works and that is repeatable. While correctly predicting one, or even two market movements may be possible, an honest investor must ask themselves whether or not these predictions are truly and consistently repeatable. For most, the answer will be a resounding NO.
One of the ways in which an investment manager adds value to your portfolio is by providing the discipline necessary to stick with a long term investment strategy. An Investment Policy Statement (IPS) is a vehicle which would provide you with that discipline. It would provide you with a long term roadmap, reiterating your goals,objectives, and risk tolerance and ensuring that you ‘stay the course. ”