Market timing is an approach to investing that involves attempting to buy or sell assets based on predictions about future market movements. Market timing can be either on a short or long term time horizon. Market timing is tough, and few can do it well. In this post, we’ll explore the viability of market timing.
Discretionary market timing is not a viable investment strategy. Holding cash has a high opportunity cost and getting exposure to the markets is crucial to build long term wealth. There are some data-driven methods of improving risk adjusted returns.
Consider a Tactical Switch strategy instead of holding cash.
Buy low and sell high. It’s easy! Right? Well, not really. There are a number of reasons why most investors can not execute on this seemingly simple idea.
In the short term, the market is inconsistent and volatile, but over longer periods of time, the market trends upwards in a predictable fashion. A sustainable investment strategy should be focused on the long-term and therefore investors should have exposure to the financial assets. We’ve plotted the rolling 3, 5, and 7 year S&P 500 performance below. This measures the performance of the market over a moving period of time. As you can see the data is mostly positive. Since 2006, the S&P 500 has only been underwater 13% of the time on a 3-year rolling time frame, and only 3% of the time on a 5-year rolling time frame. In our dataset, the S&P 500 has never been underwater on a 7-year rolling time frame. So if you invested in the S&P 500, over any given 7 year period of time in any dataset, you wouldn't have lost money. You will succeed with a longer-term mindset.
While it might seem like holding cash is a good idea, it is actually the worst performing asset class. The buying power of cash erodes over time due to inflation, and becomes worthless over a long enough time horizon. $1 in 1950 has been devalued 1,141.37% and would buy just $0.08 worth of the same goods and services today. In the current high inflationary environment, cash is losing buying power at a rapid pace.
The financial markets are inherently unpredictable and volatile, which makes it incredibly difficult to predict with accuracy. By timing the market correctly, an investor can potentially outperform their benchmark without taking on additional risk. Having said that, even sophisticated investors are unable to predict stock price movements. Morningstar found that “only 23% of all active funds topped the average of their passive rivals over the 10-year period ended December 2019“. If market timing were effective and achievable, then more investment managers would outperform their respective benchmarks.
Emotions play a significant role in an investors decision making. Many investors act irrationally based on fear or greed. This tends to happen more often during volatile bear or bull markets. A data-driven and systematic approach alleviates the risk of an investor acting in an emotional way. According to the Investment Company Institute, the top priority for individual investors is retirement planning. While retail investors have expressed their commitment to long-term investment strategies, their behavior is often influenced by emotions, which may not align with their stated goals.
We’ve plotted the hypothetical returns if an investor was to go into cash on the best trading days since 2006. The results speak for themselves. The buy and hold strategy returned a total of 348% or 8.81% annualized. If you had missed just the top two trading days your total return would drop by 28% in comparison to the buy and hold strategy. If you had missed the top 15 trading days, then your total return would be 84% less than the buy and hold strategy, a compound annual growth rate of only 2.52%. Clearly, the opportunity cost of holding cash is substantial, and investors should have exposure to the market at all times.
Surely there’s a way we can market time using a systematic data-driven approach. Let’s put this hypothesis to the test.
Trend following is a strategy that involves investing with the momentum of the market. The goal of trend following is to identify trends in market prices and take positions in assets that we expect will continue to move in the same direction. We will explore a few different options of trend following and see how they perform against the ‘Buy and Hold’ strategy.
In this strategy, we use various momentum signals to determine if the market is trending upwards. If the market does not have positive momentum then we hold cash until it turns positive again. We tested the following look back periods (the amount of time we used to calculate trend):
This dictates the look back period to check the S&P 500’s momentum. If the S&P 500 was positive over the timeframe selected, then the strategy would be invested, else it would hold cash. As we can see, the Buy and Hold strategy still outperformed the various trend-following strategies on the basis of total return. The 3,6, & 12-Month trend follower strategies have a higher Sharpe Ratio.
Another way to determine if an asset has a positive trend is to check whether the fast (short term) moving average is greater than the slow (long term) moving average. This strategy is usually implemented with a 50 and 200 day moving average. We’ve implemented and tested this strategy on our dataset and the results are in accordance with the trend-following strategy. The Buy and Hold strategy has a higher total return, while the SMA-Cross strategy has higher risk-adjusted performance.
A tactical asset switch is a smart way to navigate the market. It means moving your money from one type of investment to another depending on how the market is doing. The aim is to make more money or reduce risk by changing between aggressive (higher risk) and defensive (lower risk) investments. For example, if an aggressive investment, like stocks, has negative momentum, you might reallocate your money to the defensive investment, such as gold or bonds. This lets you keep your money in investments but lowers the risk of losing it. The goal? Better returns.
As we can see, the S&P 500-Gold Tactical Switch strategy backtests exceptionally well. It outperforms the Buy and Hold strategy on the basis of total returns and risk-adjusted returns.
Once again, the S&P 500-Bonds Tactical Switch strategy backtests well. It outperforms the Buy and Hold strategy on the basis of total returns and risk-adjusted returns.
If you are interested in learning more about tactical switch strategies, then you can see examples that we've built, on our Xplore tool.
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