Is Market-timing a viable investment strategy?
Many believe they can call market tops and bottoms and profit handsomely as a result. But this belief often leads them to exit the market too soon, and sit on the sidelines waiting for the right time to get back in. Do you believe that you have what it takes to pull this off successfully? Read on.
Some investors have a knack for calling market tops and bottoms, but their membership could probably fit into a small conference room at the local Marriott.
The odds of successfully calling tops and bottoms consistently are so small that they are essentially indistinguishable from zero. But they do exist, which is why some investors will never stop trying. The problem is that the membership in this exclusive club is constantly shrinking. Here’s why.
At any given market top there are many who will correctly call it. I’ll be generous and estimate that the odds of any investor, blogger, pundit, advisor, or strategist correctly calling a single market top is 20%. It’s what comes next that begins to thin the herd.
Calling the top is only half of the equation. If you want to have bragging rights and be invited to join the exclusive market timing club, you also must correctly call the bottom. This adds a degree of difficulty that lowers the odds of success by a factor of 10. Now the odds of success have dropped from 20% down to 2%. Since 2% is not zero, the club remains intact, but the meeting room just got smaller.
Now let’s repeat the process. Our cohort of 2% of successful timers have a 10% chance of calling the next top. So, the club is now down to just 0.002% of all investors, and they must be able to call the next bottom if they want to stay in the club.
Only 10% of the remaining 0.002% will correctly call the next bottom, which leaves us with 0.0002% who are still members in good standing.
After two market cycles our club is now small enough to meet in a large broom closet. I won’t torture you with any more iterations of this process because it should be evident by now that picking market tops AND bottoms consistently is nearly impossible. But wait… there’s some good news. You don’t have to pick tops and bottoms to increase portfolio return.
There is a lesser known, but more effective defensive strategy that can work for anyone who takes the time to set it up and follow through with it. I call it Plan B.
Plan B. means playing smart defense, and that requires three things:
- A reliable set of predictive indicators – economic, fundamental, technical, and behavioral.
- The skill to interpret these indicators correctly.
- The discipline to act only on the valid signals given by the indicators while ignoring the rest.
That’s a tall order, but it’s very doable if you have the right tools and know how to use them. There is a big difference between a garden-variety market correction and a market crash. Corrections should be ignored for the most part, but crashes call for smart defense. Below is a list of crashes dating back to 1885. If, with the help from a well-constructed defensive plan, an investor could have avoided just half of the losses shown, their average annual returns would have been higher by 4-5% per year.
Plan B. Playing smart defense
In each of the crashes shown above there was one or more triggering event. A run on the banks. A spike in inflation or interest rates. A world war. A nuclear arms showdown. An asset bubble that finally burst. Or a machine-driven selling tsunami that human traders couldn’t stop.
Fortunately there are ways to defend and protect against these destructive events. One of the simplest ways is to use a moving average crossover indicator. This involves tracking a short-term and a longer-term moving average of market prices. As long as the short-term MA is above the long-term MA, it’s business as usual.
When the short-term crosses below the long-term, it’s time to play defense. Depending on how aggressive you are, that could mean selling everything and going to 100% cash. More nuanced investors will do this in stages. It’s a binary system – go or no-go. How you execute it is up to you.
A 2-indicator Plan B.
Some investors may want to have a second indicator to confirm the signals given by the first. One obvious choice would be an economic indicator. The plan would go something like this:
If the short-term crosses below the long-term, look to the economic indicator for confirmation that the signal isn’t just normal market noise. If the economic signal is also negative, then go to Plan B. and begin to de-risk according to schedule. If the economic indicator is positive, then delay Plan B. until the two indicators get on the same page.
However you structure your Plan B. it’s more important to have one than not. You can fiddle with the controls all you want, but when the signals go off you must follow the instructions you laid out.