It's Just Money: Market Timing Works: It Reduces Risk, Not Return Potential

I know, I know, it's blaspheme. Smart investors buy and hold, market timers fooling themselves. It's time IN the market, not TIMING the market that counts, right? Market timing is a losing game. We have all the evidence, right? Miss the ten best days of the last 30 years, and your return will drop from 11.83% to 10.17%. Miss the 20 best days, and you're down to 8.98%. Miss the 90 best days and you're all the way down to 3.28% average annual return, less than T-Bills!

This fact, and it is fact, is often quoted by mutual fund sellers, but rarely understood, and almost never will you find the complete research disclosed. This is mostly because they don't know the source.

The same study that they incompletely quote, measures what happens if you miss not just the best days, but the best months. And big surprise, again, you miss out on a lot of return upside. If you miss the best 48 months from the period 1926 to 1993 (the period of the study), your return drops all the way to 2.68%. Again, less than T-Bills! The horror!

But if all of that is true, (and again, it IS true) why do I say that market timing reduces risk, not return potential. Well, let's take a close look at that study. The origin of the study is interesting, and not irrelevant to the statement of findings. An investment manager named Towneley Capital Management Inc. was looking for more information from a study that was attributed to the University of Michigan. Small problem, UofM had never heard of the study. So, Towneley commissioned a finance professor to perform said study. The intent was to show how dangerous it can be to try to time the market.

They took the return data from all stocks included in the NYSE, ASE, and NASDAQ and studies two different periods. The period 1926 to 1993 was studied for the impact of missing the best and worst months in the market, and the period 1963 to 1993 was studied for the impact of missing the best and worst days in the market.

The results are fascinating. When you start removing particular days or months, return varies wildly depending on what you are removing. The standard deviation, or measure of volatility that is used to measure risk, decreases in every case. This should be obvious. Even if you are hurting your return, you are still reducing volatility by getting out of the market at any time, even briefly.

I have always had an issue with the anti-market timing marketing that stated "if you miss the 10 (or 90) best days" your return will decline to x.xx%. My issue was two-fold. First, they never said what happened if you missed the worst days. The answer is obvious, your return goes up by a lot. But my second point is more important. What is the likelihood that you are in the market every single one of the 7,802 trading days from 1963 to 1993, except for the 90 best ones? The 90 best days that are spread out across different years and in different seasons (although several of them occurred in October 1987). The improbability of it all renders the whole idea irrelevant.

This study also give the other side of the picture. What if you manage to avoid the worst days or months in the market? The results, of course, show that your return will skyrocket. But absolutely perfect market timing is just as improbable as absolutely imperfect market timing. Both are irrelevant.

So, what if you see rocky waters ahead and bail out. Up, down, it doesn't matter. Looks volatile, so you get out. Net result, you miss the best and worst days or months of the trading calendar. Sound more realistic? Well, those results were also included in the study. Here is my summary of those results.

For the period 1926 to 1993, buy and hold resulted in an average return of 12.02%, standard deviation of 19.3% and a cumulative growth of $1 to $637.30. No doubt, very impressive.

By missing the best and worst 1, 2, 3, 6 or 12 months, your average annual return would decline to the range of 11.58 to 11.92%, your standard deviation would drop in every case. Standard deviation goes to 18.51% in the 1 month scenario, and 14.93% in the 12 month case.

However, if you avoid a larger number of volatile periods, the results change. By missing the best and worst 24, 36 and 48 months, your return goes to 12.32%, 12.73% and 13.10% respectively. Standard deviation drops to 13.39, 12.37, and 11.60% respectively. So, in the latter case, by missing both the 48 best and worst months of the 68 years studied, your return goes up more than a full percent, leading to a cumulative growth of $1 to $1080.90, and a standard deviation that is almost 40% lower. And that's for being wrong just as often as you are right.

But, what about missing the big up and down days? For that, the period 1963 to 1993 was studied. There were 7,802 trading days, and buy and hold over that period returned an average of 11.83%, standard deviation of 12.9%, and the cumulative growth of $1 to $23.30 (the period is shorter).

By missing the 10, 20, 30, 40, 50, 60 or 90 best and worst days of that period, your return would have been in the range of 12.36% to 12.42%. Surprisingly narrow range. Standard deviation declines more as the number of days out increases. When you are out the 90 best and worst days, standard deviation drops to 10.6%. The cumulative return of $1 goes to between $27.80 and $28.10.

Results: be wrong as often as you are right. Be out of the market during volatile days, whether up or down. Your return will be higher and your risk will be lower.

How exactly does that support the comment in the introduction by the fellow from Towenely Capital Management, "Market timing, then, is perhaps even more difficult and risky than investors have been led to believe."

Difficult, maybe. Risky? No. By any measure that analysts use to measure risk, it will show that less risk is taken by market timing. The greatest risk is missing some upside potential. But we have seen here, that it is still quite possible to achieve returns that are comparable, or even better than a buy and hold strategy. How do you measure the volatile periods, and miss both the best and worst periods in the market? Well, there are numerous strategies out there, not the least of which are two that I have already reviewed, Sell in May and go away, and the Super Bowl Indicator.

Again, these hokey, decades or centuries old sayings prove to bear out pretty decent results.

Of course, the greatest risk is that you will act emotionally, selling only after the market has already dropped to its bottoms, thus participating in the worst days, and buying only after the market has risen to its highest levels, thus missing the best days.

And most importantly, read my disclaimer: This is general advice. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio. You, alone, are responsible for any losses or damages that may and will likely result from your financial decisions.

Comments

Great post LAMoneyDude. ;) Thanks for taking the time to break down historical data...I guess since most of my investments were made in the late 90's, I've encountered a majority of "down days." Thus my returns have been, well, non-existent. Another example of poor timing on my part, after working 2.5 years the value of the stocks I purchased/owned through my employee stock purchase plan finally increased beyond what cash I actually put into buying them. Now how to determine "volatile periods"...any ideas?

Posted by: financial freedumb | June 19, 2006 at 05:06 PM

Not risky by standard analyst measures of risk. Yet what would Ben Graham say about risk? It's not about market value fluctuation, it's about buying a good company's stock at a reasonable price and not being forced to sell at a bad time.

Posted by: Matt | June 21, 2006 at 08:50 AM

Thanks FF, there are numerous measures, none stand alone, but combined may provide help. Most of the measures used by technical analysts are designed to identify topping or bottoming points, but as shown above, if you are right 50% of the time, you may still do well.

Matt,
I agree that value investing is far superior to efficient market hypothesis based investing. This post was really to poke fun at EMH, showing that even trying to time the market with no real system can result in better return with risk (in the way the EMH proponents measure it) being reduced.

Posted by: lamoneyguy | June 21, 2006 at 09:31 AM