Market Timing: A Perilous PloyJeffrey M. Laderman
The idea of marrying mutual-fund investing with market timing has innate appeal. With a phone call--or a few keystrokes at a Web site--you switch your money into equities when the stock market's going to rise and take it out before stocks go down. Who, after all, wouldn't want to ride the bull and dodge the bear?
Trouble is, market timing hasn't worked very well during Wall Street's 15-year bull market--certainly not as well as the tried-and-true approach of buy and hold. Take a look at the long-term record of market-timing newsletters offering advice for mutual-fund investors and money managers who run timing portfolios. Most of them trail the market and even the average diversified equity fund. Worse yet, if you attempt market timing outside a tax-sheltered account such as an individual retirement account or a 401(k), you'll cede around a third of your profits to Uncle Sam. That's because timers trade hyperactively, and profits on positions held less than one year are subject to the same tax rate as on ordinary income. Some mutual funds allow cash to build up, but almost none are outright timers.
GUESSING GAME. It's no wonder, then, that timers are unloved on Wall Street. Once-hot newsletters such as The Elliott Wave Theorist and The Professional Tape Reader have flamed out as the bull has run on and on. "Sometimes people have shown an ability to outguess the market in the short run," says Derek Sasveld, a consultant at Ibbotson Associates, an investment research firm. "Then conditions change, and they can no longer replicate that behavior."
Perhaps timers are scorned by the Establishment because they're a reminder of the 1970s, when Wall Street was in a funk. "That was the golden age of market timing," says Steve Shellans, editor of the MoniResearch Newsletter (800 615-6664), which reports on market-timing money managers. "The market went up and down, but at the end of the decade, stock prices were no higher. The buy-and-hold crowd made no money, but timers did."
Two decades later, the timers seem hopelessly out of sync. We asked The Hulbert Financial Digest (703 683-5905), which tracks investment newsletters, to measure market-timing advice tailored to mutual-fund investors. In all, publisher Mark Hulbert identified 25 newsletters with 32 portfolios, since some newsletters have more than one timing model.
Hulbert's conclusion: None of the newsletter timers beat the market. For the 10 years that ended Dec. 31, the timers' annual average total returns ranged from 16.9% to 5.84%. The average return was 11.06%. During the same period, the Standard & Poor's 500-stock index earned 18.06% annually, and the Wilshire 5000 Value-Weighted Total Return Index, a broader measure of market performance, 17.57%.
STANDOUT. Hulbert and others argue, however, that raw returns are not a good way to measure timers, since they're often in cash and thus have less exposure to the market's volatility. So we calculated what the timers' returns would have been if they had taken on the same risk as those who remained fully invested in the Wilshire 5000. On that basis, the timers looked better. But their average annual return rose to just 13.87%--nearly two percentage points behind the average U.S. diversified equity fund.
Among newsletters, Market Logic's Seasonality Timing System stood out (800 442-9000). It's based on the market's propensity to rise on the last day of the month, the first four days of the next month, and the two days before market holidays. Market Logic Editor Norman Fosback, who developed the system, says he invests in selected no-load funds right before those days and exits at the end. The record: about 16% a year for the past 20 years.
Investment managers who mix mutual funds and market timing don't appear much savvier than the newsletter crowd. MoniResearch tracks 85 managers with a total of $10 billion, and divides them into "classic" timers, who are either in equity mutual funds or cash (Treasury bills or money funds), and "dynamic asset allocators," who move assets around to other categories such as bonds, foreign stocks, and precious metals. Of the classic timers, the best 10-year performance was 16.9% a year, the worst 4.4%. The average of 24 timers with 10-year records was just 10.9%. The dynamic asset allocators looked better because they had more asset classes to choose from, says MoniResearch's Shellans. The best of those managed a 22% average return, the worst 7.0%, and the average 14%.
Why do timers seem so inept? The stock market makes dramatic moves in relatively short periods, and those who miss them effectively miss a lot of the gains. For example, the Standard & Poor's 500-stock index has had an 18.05% average annual return over the past 10 years. But if a market timer had been in Treasury bills during the market's best month, the 10-year average drops by three quarters of a point, says Crandall, Pierce & Co., an investment research firm. Take out the six best months, and the return falls to 12.55%. With small-cap stocks, the moves are more dramatic, and missing the six best months slices the return by 40%.
Downward moves can be swift as well, and one of the allures of timing is the hope of avoiding them. A 10-year investment in the S&P 500 less the six worst months would boost results to a 22.8% average return, according to Crandall Pierce. Even missing the one worst month hikes returns by nearly one percentage point a year.
But up and down moves aren't a matter of a coin toss. Over long periods, the stock market goes up more than it goes down. So timers, some of whom spend only one-third of their time invested and the rest in cash, end up missing some neat moves. In fact, timers are better at getting out of the market than finding their way back in, says Jim Schmidt, editor of Timer Digest (203 629-3503). "The market can jump 4% or 5% after a fall, and the timer will wait to reenter, expecting the prices to come back down. But when prices don't, he ends up buying in at even higher cost or missing the move altogether."
Another reason for the timers' poor results is that they err on the side of bears. One who hasn't is Don Wolanchuk, who was named top timer for 1997 by Timer Digest. Wolanchuk says that except for a few brief periods, he has been bullish for 10 years. According to Timer Digest, Wolanchuk's timing returns work out to 20.2% a year for the eight years ending in 1997, vs. 13.5% for the S&P 500. Wolanchuk delivers advice on an $8,000-a-year hotline or a $2.75-per-minute 900 number. (For more information, call 800 511-0781.)
Most timers defend their systems as a way to minimize risk. If that's your goal, there are better ways. One method, which is easy with mutual funds, is to diversify into other asset classes such as bonds, foreign equities, and real estate. Another way: Split your portfolio between an S&P 500 index fund and money funds, and rebalance annually. Over the last 10 years, that would have yielded a 12% average return--a good deal better than many timers.