Market Timing Strategies that Work – Day 2

Given the recent market volatility I thought I’d republish the following post.  Is it really possible to time the market? Maybe not in the traditional sense but market “timing” can help you navigate very choppy investment waters.  Read on and find out how.   

 

There are market timing strategies that work. Now that I’ve disturbed you, let’s make sure we agree on what market timing is. When I Googled “market timing,” I got a page full of very different definitions. The “market timing” I’m talking about refers to the practice of buying and selling securities over a relatively short time period in an effort to outperform the market.

And yes…it can work (over the long-run).  Of course, it doesn’t work for most people and you’ll see why in a minute.

What do I mean when I say it”works”?

When I say market timing “works” I mean it can help you achieve your long-term goals. Even if you are  already retired, this is an approach that can have merit. Of course you must do your homework and select the right strategy – the strategy that is most consistent with your financial psyche (there are many different ways to time the market). It “works” if you stick with that strategy even when it does poorly for a period of time – because it will underperform at times.

When I say it “works” I mean it might protect you from catastrophic investment losses sometimes – but not every time. Finally, “works” means it might help you achieve your financial goals better than “buy and hold” over the long-term.

What good is something that “might” work? Well, in the investment world, if an approach makes more money than it loses over the long-run, “might work” is pretty attractive.

Not good enough for you eh?

What? All of a sudden you want perfection? Does your car work perfectly? Does your computer work flawlessly? Why would you expect anything to be perfect? Sheesh.

I’ll be the first to admit that market timing isn’t perfect. Not just that. It can really stink over the short-term. It may do just as well, much better or much worse than “buy and hold” over the short-term. This is what trips people up. If you expect market timing to always do better than other strategies, you are breaking important investment rules — you’re trying to have your cake and eat it too. In order for your strategy to “work” you have to approach market timing as a long-term strategy and not a short-term cure.

When does market timing fail?

If you try to time the market based on your gut feeling….you aren’t market timing at all. You’re trying to predict the future. Your “gut” tells you such and such is going to happen and as a result you take a certain course of action. We’ve already agreed that you can’t predict the future, so market timing based on your gut is out. Cabishe?

Good.

To the examples.

As I said, market timing works only when you take a systematic, methodical approach using objective data to guide your tactics. Let’s look at one market timing strategy that does just that. Take a look at the performance chart below:

This is a chart that shows you the real-life performance of a newsletter that times the market. The company tells you what funds to buy, what funds to sell and when to do it. (Please don’t ask me to tell you the name of this company. I can’t provide investment advice through this blog — that would be illegal. And if I release the name of the company, that would be giving advice. You don’t want to visit the Wealth Pilgrim in jail do you? I thought not.)

The chart shows that over 28 years, the investor who used this timing service did pretty darn well. In fact, had you invested $1,000 and used this particular timing service, you’d have about 2 1/2 times as much money as you would if you just bought and held the S&P 500. The timing method ended up with $5,066 versus $1,702 with the S&P 500. These are facts. They cannot be disputed.

So how could investors lose money using such a fantastic investment approach?

Had you invested using this service, you’d have beaten the market over many years — but not every single year. In fact, look at 1994 through 1998. Their performance versus the S&P 500 was sub-par. There were some years where the market made money and this service lost money — 1987 is an example. Other years, people using this service lost more than the market (1990). In fact, this company freely admits that they often underperform the market and they could underperform for 48 months or longer. To make matters worse, people using this service weren’t protected against big losses. While investors did really well using this service from 2000 through 2002, they got their clocks cleaned in 2008.

Do you see what I’m saying here? This strategy did great in the long-run but in any one year, it may do much better or much worse than the overall market.

Using 20-20 hindsight, you might say that you would accept that trade-off. Of course you would if you knew what the outcome was going to be. But during the heat of the battle it might be too much. You might tell yourself, “I don’t care about the long-term track record. I’m losing too much money. This time it’s different. Get me out!” It’s only natural to feel this way when you want to protect your assets. So even though a strategy has a fantastic long-term record, people abandon their timing strategy because emotionally, at some point, they just can’t take it anymore. They can’t help it. They break Rules 1, 2 and 3. Trifecta!

So this is one of many timing approaches that has a great yet imperfect track record. People often expect to have a perfect investment and when they discover that they don’t, they get upset and make a change. They don’t want to play anymore. They take their marbles and go home. This is why few investors can take advantage of the market timing approaches that do work (many do not).

Need another example? Remember the “Dogs of the Dow”? This was a strategy that invested money in 10 stocks that are in the DJIA 30. The strategy asked you to buy the 10 stocks with the lowest price and the highest yield and rebalance these stocks each year. This was very popular in the mid-90’s because the track record was fantastic. Then, in 1999 the tech stocks took off. The NASDAQ returned over 62% in 1999. The DOGS program returned only 4% that year. Investors dumped their dogs and trounced on the tech stocks. What happened in the very next year? The NASDAQ lost over 67% in 2000.

Look at the chart to the right. It shows the cumulative value of an investment of $10,000 made in January 1999. It shows your initial $10,000 growing and then shrinking from 1999 through 2002.

Let’s go back to January 2000. You made 4% in 1999. Your show-off neighbor made over 60% last year in tech stocks. Do you think you’d stick with this DOGS strategy in 2000? Probably not. And you wouldn’t be alone. Many investors dumped the Dogs of the Dow strategy and went to tech stocks just in time to lose a fortune. Had you stuck with your “Dogs” strategy throughout the bear market, you’d have 60% more of your capital than the tech junkies. But again, staying put is against human nature, and that’s why investors lose money using a timing approach.

Summary

The big problem with timing the market isn’t always the system (but it certainly could be). The big problem is you. If you rely on your gut feelings to time the market you are breaking Rule 2 because you are really just trying to predict the future. If you bail out when the going gets tough, you are breaking Rule 1 – you are changing your timeframe. If you don’t do your homework and don’t find a good approach with a long track-record of success, you’re breaking another rule…I just don’t know what number it is…

I am not trying to sell you on market timing. I am pointing out that if you take a methodical, adult approach and if you are willing to underperform for some time periods, it can work out very well for you in the long-run.

Click here to see my next post when we’ll look at why “buy and hold” works but fails most investors and what you can do about it.