A Market Timing Strategy That Works?

Mark Meredith, CFP®
“The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently.” - John Bogle

Conventional financial advice would suggest market timing is a fool’s game, and that over time many investors would have been better off buying and holding a diversified portfolio of different asset classes rather than moving in and out of the market.

With the incredible benefit of hindsight, let’s look at a simple yet popular approach to market timing. Below we will compare two portfolios, the “buy and hold portfolio” will invest the entire balance in the Vanguard S&P 500 index fund (VFINX). The “timing” portfolio will also initially invest the entire balance in the Vanguard S&P 500 index fund and shift the entire balance to the Vanguard Short-Term Treasury Fund (VFISX) every time the 500 index falls below its trailing 10 month average price (or commonly referred to as the 10 month simple moving average).

The earliest start date I can use is January of 1992, so we will invest $10,000 on that day in each strategy and run the test through November of 2019. Here are the results:

By those results, the timing model looks incredible. Why wouldn’t everyone do this? For one thing, if everyone did it, it would not work. Also, in January of 1992 you wouldn’t have known in advance it would work. You can see the timing model did a good job of avoiding the collapses from the tech bubble and from the Great Recession. The question is, will it work in the future and what are the pitfalls of such a strategy?

False Signals

For one, the timing model is wrong A LOT. From 01/2012 – 11/2019 the timing portfolio would have underperformed buy and hold by close to 5% annually. The false signals would have incorrectly suggested a move the to short-term treasury fund 6 different times during that period.

For example, the timing portfolio would have sold an investor out of stocks in November of 2018, missing a 2.03% gain for the month. Then, it would have put you back in stocks in December of 2018, causing you to lose 9.04% for the month. AND, it would have kept you out of stocks until March of 2019, causing you to miss about an 11.50% recovery.

These false signals and missed returns would be a constant psychological battle for any investor, and would likely have them questioning their faith in such a model.

Small Sample Size

The period of 01/1992 – 11/2019 may seem like a mountain of data to judge such a strategy on, but it isn’t. There happened to be two major market crashes during that period and they both developed slowly, which is helpful when using such a trend strategy. The quick sharp declines like we saw in December of 2018, are not avoided by such a timing strategy, they are actually made worse since you are unable to participate in the recovery.

Data Mining

Is there any logical reason to believe this strategy will continue to work other than the fact that it seems to have worked well in the past? Why does the 10 month moving average work better than the 6 month or 3 month? What if you use the 10 month strategy and the 5 month is the best going forward? You’ll be disappointed.

If future market declines develop quicker and recover faster, the 10 month strategy will not work and your portfolio balance will reflect that. This is exactly what has happened during the current decade.

Investing is about owning a share of business and participating in their earnings, dividends, and appreciation. Trading is not investing, it is speculation.

Use A Strategy That Works For You

I believe in markets and that owning a share of global business will result in generous returns to investors in the long run, while tilting towards cheaper/profitable/smaller companies could further improve those returns a bit. To me, lowering risk means having less money invested in stocks and more in fixed income. That doesn’t mean it’s the only path to success.

Warren Buffett cemented his face on the Mt. Rushmore of investing by allocating capital towards great companies he was able to identify in advance by ripping through annual reports and financial statements. A fellow named Jim Simons was able to achieve annualized returns nearly double Mr. Buffett, and he has never reviewed a company’s financials, earnings, or projections. Ed Thorp made his fortune practicing convertible bond arbitrage. All 3 of their strategies are very different, but they have all worked quite well.

Using a market timing strategy like this would take an incredible commitment, as it is likely to fail much more than it works. It’s not a strategy you’d want to try for a year or two and then give up, you would likely want to employ it for several decades (and even then it might not work!). Unfortunately, we only get so many decades in our investment lifetime and the cost of screwing them up can be tremendous.

This article is for informational purposes only and is not a recommendation of Meredith Wealth Planning or Mark Meredith, CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the Article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the Article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.

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