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Financial Times - Market timing: don’t try this at home

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What is meant by market timing? It’s the classic investor aim: to buy low and sell high.

This can be applied to individual stocks or funds, trying to buy them at the bottom of a business or market cycle and sell close to the top; or to the timing of committing your funds to the market as a whole – waiting for a market bottom before coming out of cash and taking the plunge, and cashing out when the market is at a top.

Nothing wrong with that, you might think. Surely it enhances your return to miss the fall in markets from a peak and get back in for the recovery from its lows? It does indeed. The trouble is that very few, if any of us, are any good at it.

There is quite a lot of data available about investors’ behaviour and as the chart shows, investors’ flows into and out of funds mainly achieve the opposite of what is desired. Money flows into markets and funds when they have risen and flows out when they have fallen – precisely the opposite of what effective market timing would require.

Professional investors, such as fund managers and trustees of pension funds and endowments, may scoff at this as the typical herd instinct of retail investors. But the available evidence suggests that they are no better. The average active fund manager underperforms the market, and Cambridge Associates’ data clearly shows that the average pension fund or endowment decision to hire or fire a fund manager is just as mistimed.

It is not hard to see why we are almost all bad at market timing. It is hard enough to have the strength of conviction to convince yourself that markets are too high and sell when the background is looking rosy and everyone else is bullish. But it requires an extraordinarily flexible psyche to be able to complete the required volte face at the bottom and buy the stock, market or fund after your predictions have come true, its prospects look bleak and the price has fallen.

Another way of looking at this problem is to examine how few days you need to miss being in the market to seriously damage your investment returns. If you take the decade from December 31 1994 to 2004, the S&P 500 Index produced a compound total return of 12.07 per cent each year. That’s what you would have got – before costs – if you were fully invested in the index. Put another way, $10,000 invested at the outset of the ten-year period would have become $31,260 by 2004.

But what if you have tried some market timing moves and as a result missed a few days in the market, which happened to be some of its best days in that decade? What if you missed just the best 10 days? That’s not much, is it – one day per year on average. Maybe, but your return would be cut to 6.89 per cent a year and you would be left with $19,476. If you missed the best 30 days, your returns would be negative.

You may argue that you might also have missed some of the worst days, but all the evidence is that there are more good days than bad days. Do you really think you are good enough to spot those days and make sure you are fully invested ready for them? I know I’m not.

Which brings me to my punchline: there are only two types of investors – those who know they can’t make money from market timing, and those who don’t know they can’t. This is why I seek to follow the advice from a great investor, which is that you should buy low and sell high, but if you are buying stocks in high-quality companies it doesn’t matter if you forget the second bit. But that’s an article for another day.

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Terry Smith

Financial Times