Does Market Timing Ever Work? - YouTube

- Even the most rational index investors

might catch themselves wondering

if they should sell some of their equities,

or delay investing new cash

because of expected market volatility,

or reports of record high stock prices.

And if the market does happen to drop,

our brains will allow us to believe that we were right,

which might increase the future impulse to time the market.

That is called confirmation bias.

It is not a good way to make financial decisions.

Instead, we should look at the data on market timing

to see if it is a viable strategy.

I am Ben Felix portfolio manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you what the data say about market timing.

(bright music)

Before I get into the episode,

I wanted to take a moment to thank all of you

for watching and subscribing.

I didn't really know what to expect

when I started making these videos two years ago,

but the response has been excellent

and it feels like there's a great community

building around the channel.

One of the biggest challenges

in thinking about timing the market

is that there is actually data showing

that when markets are expensive,

future returns tend to be lower.

This might make it seem obvious

that if stock prices are high relative to the past,

it might not be a good time to be in the market,

or at least not a good time to invest new money.

The most reliable metric that we have

for forecasting future returns

is the Shiller CAPE or a cyclically adjusted price earnings.

If we look at market history, periods of high prices

have often been followed by lower returns.

Take a look at the annualized excess returns for stocks

that have been sorted quarterly based on valuations

using the Shiller CAPE.

This chart is from an AQR paper

titled "Market Timing, Sin a Little."

On the left we can see that the bucket

of the most expensive stocks

has a substantially lower return

than the bucket of the least expensive stocks on the right.

There is clearly a relationship between current valuation

and future returns.

Well it may seem like I'm making argument

in favor of market timing, I can assure you that I'm not.

One problem here is that the data that we just saw

has a meaningful hindsight bias built into it.

Think about it.

If we sort stocks every quarter,

based on their valuation relative

to all of the history that we were examining,

we are cheating.

A real investor would not know

what feature evaluations are going to be,

which would make their evaluation based

sort far less effective.

Stocks may look expensive relative to history today,

but relative to the future, which we can observe,

they may look cheap.

This causes an obvious problem for market timers.

In the same AQR paper.

They adjust for this hindsight bias

by sorting stocks at quarterly,

based on only the past 60 years of data ending each quarter.

With this method, we are getting results

that are real investor may actually be able to capture.

The results in this case are much weaker.

There is still a trend toward lower return

when stocks are most expensive,

but it is much less obvious

than in the case of perfect foresight.

Even though it's weak, there is still a relationship.

When stocks are expensive relative to the past,

future returns tend to be lower.

The real question though

is whether or not you can use this information

to make investment decisions.

The AQR paper also asked this question.

They built a market timing strategy

that adjusted the weight in stocks based on valuations.

They tested the strategy on data from 1900 through 2015.

For the full sample,

the timing strategy did add value to returns,

but it underperformed from 1958 through 2015.

The author suggests that this may be due

to stocks becoming more or less cheap

for very long periods of time.

In other words, from 1900 through 1957,

stocks were generally cheap relative to their past resulting

in the timing strategy being more than 100% invested

in stocks due to leverage for most of the time period.

From 1958 through 2015,

stocks were generally expensive relative to the past,

resulting in the strategy being under-invested

for most of the time period.

The paper sums this up as follows.

"Valuations can drift higher or lower

for years or decades making it difficult

to categorize the current market confidently as cheap

or expensive without hindsight calibration,

and therefore difficult to profit

from such categorizations."

One of the other challenges

with using signals like the Shiller CAPE to time the market

is that even after a signal may suggest

that lower returns are coming,

there may still be more high returns to come.

There is evidence that when stocks have been increasing

in price, they tend to continue

on that trajectory for some time.

This is known intuitively as momentum.

Stocks will start to look expensive

based on metrics like the Shiller CAPE,

because they've been going up in price.

Selling them at that point

means that you are betting against momentum,

which is a well-documented phenomenon.

We also have to remember that most of the market's returns

come in a relatively small number of trading days.

Take a look at this data for the S&P/TSX composite index.

From 1977 through 2018, the index returned 9.72%.

If you missed the single best trading day

over that full time period,

the annualized return drops to 9.48%.

If you missed the 15 best days,

the annualized return drops to 7.44%.

That's more than a 2% drop in annualized returns

for missing a tiny fraction of the total trading days.

Now, the probability of missing the 15 best days

may not be any better than the probability

of missing the worst 15 days.

So this is an extreme example,

but the point is that you have to stay in the market

if you want to get the market's returns.

I think that even for the most rational investors,

the urge to market time will be the strongest

when there is a lump sum of cash to invest.

It's scary looking at your pile of cash

and knowing that it could drop substantially

the day after you invest it,

especially when there is so much uncertainty in the market.

Let me tell you something that I've learned

after having hundreds of conversations like this.

The market always feels uncertain.

Feelings of uncertainty are not basis

for market timing decisions.

One simple trick that many people are familiar with

to alleviate such concerns is dollar cost averaging.

Instead of investing $100,000 today,

you invest $10,000 per month over the next 10 months.

This alleviates any concerns over investing

at the worst possible time.

But unfortunately that is all that it does.

Dollar cost averaging is systematic which is good,

but at the end of the day,

it is still a form of market timing.

Dollar cost averaging should not on average

give you a better result

than investing your lump sum of cash right now.

Vanguard study this in a 2012 paper

titled "Dollar Cost Averaging Just Means Taking Risk Later."

They tested lump sum investing against dollar cost averaging

over 12 month periods from 1926 through 2011 in the U.S,

1976 through 2011 in the UK.

And from 1984, through 2011 in Australia.

They found across stocks, bonds,

and a 60/40 balanced portfolio

in all geographic regions tested,

lump sum investing beat dollar cost averaging

roughly two thirds of the time.

As we have seen, there is a relationship

between current market valuations observed

by the Shiller P/E and expected future returns.

As tempting as this seems,

that relation and ship is not reliable enough

to provide any meaningful information

for investment decision-making.

Before anyone tells me

that they would base their market timing decision

on intuition as opposed

to evaluation metric like the Shiller P/E,

let me tell you what Nobel Laureate Denny Conaman

told the 71st CFA Institute Annual Conference.

"It is very difficult to imagine

from the psychological analysis of what expertise is

that you can develop a true expertise in say,

predicting the stock market.

You cannot because the world isn't sufficiently regular

for people to learn rules."

Market timing is hard.

You have to get out at the right time,

which is hard to do even

with the most reliable forecasting metrics

that we have available.

And then you have to get back in at the right time.

Even if you missed the right time by a few good days

in the market, you can seriously hurt your longterm returns.

I haven't even talked about the trading costs

and taxes incurred to jump in and out of the market,

which depending on the circumstances

could have a large negative impact on returns.

John Bogle, Vanguard's legendary founder

famously said about market timing;

"after nearly 50 years in the business,

I do not know of anybody who has done it successfully

and consistently.

I don't even know of anybody who knows anybody,

who has done it successfully and consistently"

If you are sitting on cash to invest and feeling nervous,

I think that dollar cost averaging,

well, statistically suboptimal and a form of market timing

is much better than sitting on the sidelines waiting

for the perfect moment.

Have you ever caught yourself timing the market?

Tell me about it in the comments. Thanks for watching.

My name is Ben Felix of PWL Capital,

and this is Common Sense Investing.

If you enjoyed this video,

please share it with someone who you think could benefit

from the information.

Don't forget if you've run

out of Common Sense Investing videos to watch,

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of the Rational Reminder podcast,

wherever you get your podcasts.

(upbeat music)