Lindy, This Might Help. :)
September 11, 1999
Do you have what it takes to be a successful market timer?
Market timing works, and it works well for people who actually practice it as a discipline. In theory, every investor is capable
of following the disciplines of timing. But not everybody has the right emotional makeup to do timing right. In real life, most
people who try are ultimately unsuccessful. Timing puts investors on the front lines, face to face with the realities of the market,
every business day. To be a successful timer, you've got to buy and sell without flinching even when you don't feel like it.
You've got to follow your discipline even when you're sure it's a mistake. You've got to do it even when you don't understand
why your timing system is telling you to act. Nike had it right: "Just do it." But it's so much easier to say than do!
This month I'm going to share with you a list of 10 keys to being a successful market timer. And I'll tell you some
uncomfortable truths about timing, what it's really like when it's not fun. But even the best tips in the world won't be of any
value to you unless you put them into practice. And no matter what you think, you probably won't do that unless you have the
right emotional temperament to be a timer.
Timing is not for sissies. Sometimes it takes strong faith and a strong stomach. I like this quote from the legendary Benjamin
Graham: "To achieve satisfactory results is easier than most people realize. To achieve superior results is harder than it looks."
Here are six questions to help you determine if you have what it takes. (Long-time Fund Exchange readers may recognize this
topic from an issue we published five years ago.) There are no right or wrong answers, only what's true for you.
Six questions
1. Do you have the necessary perseverance?
Timing can get you in real trouble if you try it for awhile, become discouraged and then abandon your plan in favor of something
you find more palatable. If you let your feelings guide you, you're likely to bail out of a timing strategy at the very worst time,
when your investments are down. Can you adopt a strategy and stick to it for the long term? Can you follow the system
regardless of how you feel about it and regardless of what's going on around you? Can you resist the temptations to act on
impulse? Can you ignore the many "hot tips" you may come upon every week?
2. Are you independent and self-assured enough to resist the temptation to constantly look over your shoulder to
see how somebody else is doing?
There aren't many certainties about investing, but here's something I can guarantee: no matter how your investments are doing,
there will always be somebody who has recently outperformed you and seems to have struck it rich. Nervous investors
constantly look over their shoulders, hoping to find somebody who has found "the one true path" to wealth. That path is a myth,
and nervous investors don't make good timers. Confident, successful investors know what they want and need, adopt a
strategy to achieve their objectives and stick with that strategy regardless of what others are doing. If your goal is to increase
your assets by 10 percent a year, and a timing system lets you achieve that, can you be satisfied even when other people are
making 12 percent or 15 percent or even 20 percent? If so, you may have what it takes to succeed as a timer.
3. Can you accept that your portfolio will underperform the market?
This should be obvious, but you would be surprised to know how many people forget it. A timing system is not designed to
produce the same returns as the untimed market. When you outperform the market, you are likely to be pleased. But your
pleasure may be mild compared with the fury or betrayal you can experience when your portfolio is under-performing and
when your timing system produces a losing trade. That's especially true when you just "knew" that the signal you got from your
system was the wrong thing to do.
4. Can you accept that your timing system will be imperfect?
Imperfection is one of the media's biggest criticisms of timing. When you are underperforming and experiencing losing trades,
that media criticism may shake your confidence. The media often says market timing requires you to be right twice: when you
buy and when you sell, in contrast to a buy-and-hold approach in which you have to be right only once: when you buy. Most of
the time, you can count on your system to get you into or out of the market "too soon" or "too late" to catch the tops and
bottoms. If getting out at the very top and getting back in at the very bottom are your goals, timing is guaranteed to let you
down. And if that failure will drive you nuts, think twice before embarking on a timing strategy, because what you will perceive
as timing mistakes will erode or destroy your willingness to follow the discipline. Your goal should not be to achieve perfection.
It should be to put the probabilities on your side. And a good timing strategy will do that.
5. Can you ignore the mass media?
Almost unanimously, the popular press seems to have a blind spot when it comes to timing. They say timers are misguided, and
this view is widely echoed by the mutual fund and brokerage industries. Can you pull out of the market when everybody else is
either getting in or already making money? Can you get back in when your friends, colleagues, the media and possibly your
own gut are telling you it's a dumb idea?
6. Are you decisive?
Some people stew and fret and delay making decisions, even when they are convinced they should do something. They are
unlikely to be successful timers. Successful timing requires quick action to move into and out of markets. One of the most
obvious truths about timing (and one of the most widely overlooked) is that by the time your friends, your colleagues, your gut
and the experts all agree on what you should do, it's already far too late for you to extract the maximum opportunity from it. If
you usually take lots of time to make decisions, this is not a suitable arena for you.
10 Keys to Successful
Market Timing
If you have the emotional makeup for it, timing can reduce your risks and enhance your returns. If you're satisfied that you have
what it takes to be a market timer, here are the best tips I know for doing it successfully. They aren't necessarily listed in order
of priority. In fact, I suggest that you regard each one of them as the top priority.
1. Use mechanical strategies.
Timing financial markets is already plenty hard without worrying about making predictions or (even worse) thinking you have to
decide who is right when smart economists and savvy analysts make conflicting forecasts and draw different conclusions. If you
leave the final decisions to subjective factors, you will never be sure what you are supposed to do at any given moment. That
will cause you anxiety and delay. And you'll have a system you can't count on. Rely primarily on trend-following systems that
are based mainly on trends that are impacted by actual prices in the market. There's nothing speculative about prices. They
reflect what buyers and sellers are doing, and that's about as reliable an indicator of the direction of the market as you can find.
2. Do not -- repeat DO NOT -- pay much attention to the effect of every trade.
The majority of individual trades will be irrelevant to your long-term results. If you feel you must focus on each trade and
agonize over what it means, that's a sure sign you are not cut out to be a successful timer. Dwelling on each trade is a sure way
to drive yourself nuts, and it won't improve your results at all.
3. Use timing systems that are right for you and your temperament.
The perfect strategy for you will match your time horizon, will respect your emotional needs and will operate within your
tolerance for risk and change. There are short-term systems that trade frequently, long-term systems that trade infrequently and
intermediate-term systems that typically trade two to six times a year. Over long periods of time, no group has an inherent
return advantage over the others. But the practical and emotional differences are important. If you have a strong desire to
perform closely in synch with the market, use short-term systems, which are good at quickly reacting to today's highly volatile
market swings. However, short-term systems demand that you make many trades, and each trade has potential tax
consequences unless you are investing in a tax-sheltered account. The volume of trades demands a lot of attention, produces a
lot of paperwork and tests the patience of many mutual funds, which sometimes won't accept accounts from very active timers.
If on the other hand you have a strong aversion to whipsaws, you can use long-term systems. But doing so will sometimes
make you wait for a move of 20 percent or more before you buy or sell. For the best compromise, do as we do: Use
intermediate-term systems. This level of activity is likely to be accepted by most mutual funds and is not too demanding
emotionally.
4. Use multiple timing systems, stick with them and let them act independently in your portfolio.
Even the most productive system from the past may be a mediocre performer in the future, and the reverse could also be the
case. We use four U.S. equity timing models, each of which governs 25 percent of our portfolio. We have faith in the systems
as a group. But we don't have enough faith in any one system to let it govern the whole portfolio. You shouldn't either. Just as
you should not chase recent performance in your choice of mutual funds or asset classes, do not chase recent high-flying timing
systems. One of the smartest timers in this business, a fellow newsletter publisher whose work I respect, has averaged about 9
percent over the past decade. He chooses good timing systems, which have produced average returns of more than 18 percent
before he adopts them. But he doesn't stick with those systems. Whenever the system he has been using disappoints him, he
finds another one that would not have done so, based on real or hypothetical past performance, and then he switches to that
system. In theory, this may seem like a valid way to search for the very finest system on the planet. But in truth, such "superstar"
timing models simply do not exist. They are a myth. Good performance one year doesn't mean anything about performance the
next year – not anything. This is one of the hardest facts for investors to accept, but it's true. Therefore, we believe your best
bet is to find several robust timing models and stick with them.
5. Remember that whether you use a buy-and-hold approach or market timing, asset allocation is the most
important investment decision you will make as an investor.
Use many assets or asset classes that move up and down at different times and at different speeds. Include international
diversification, whether you invest in equities, bonds or both. Just as you never know which timing model will be the star
performer in a given quarter or year, you never know which asset class will be the overachiever and which will be the laggard.
6. Follow your systems and your strategy.
Put them into action without fail and without exception. Remember this Chinese proverb: "He who knows but does not act, still
does not know." If you do only one thing right and everything else wrong, make sure this is the one thing you do right. This is
the most essential key of all. If buying diet books and exercise equipment took off pounds, obesity would not be a major health
concern. You can devise the greatest portfolio in the history of investing, but it will do you no good unless you commit your
money to it. The greatest timing models do you no good unless you apply them. Therefore, do whatever is necessary to get it
done.
7. Before you start timing, take off the rose-colored glasses, if you are wearing them.
Focus in advance on the difficulties you can expect as well as the ultimate rewards you hope to achieve. Accepting the rewards
of success will be easy. But you'll never get to the finish line unless you can deal with the hurdles along the track. Know the
level of interim losses you are likely to encounter with your strategy, and make sure you are willing to accept them. In the early
1970s, buy-and-hold investors in the Standard & Poor's 500 Index suffered a 39 percent loss in one year. Even timing can be
ugly. In our Worldwide Equity strategy, all our back-testing has failed to produce a decline as high as 15 percent in any
12-month period. Yet we believe that any strategy with the potential to produce returns of 13 to 15 percent a year also has the
potential to lose 15 percent in a year, so that's the figure we use when we project the expected worst-case scenario. Bottom
line: Do not expect magic from any timing system.
8. Give timing enough time to work. In the short term, anything can happen.
In the long term, if you have chosen a strategy carefully and you follow the discipline, you should be rewarded accordingly. But
how long is long enough? There are two places to look for the answer. The first is in your own psychology. Do you normally
undertake long-term projects or strategies, comfortable knowing that you'll have to wait for any payoff? If so, you may be a
good candidate for market timing. But if on the other hand you are usually quick to judge the success or failure of something
you start, and if you need instant gratification, you'll probably have trouble being a successful market timer. The second place
to look for the answer is in statistics and history. Arm yourself (or have your manager do this for you) with the past statistical
performance, either real or hypothetical, of your proposed investment. Over the longest period for which you have data,
determine the depth of the largest drawdown. Find out how long it took to return to break-even. One of our most aggressive
timing programs, which we call by the shorthand of +2 to -1, meaning it attempts to double the performance of large U.S.
stocks when the market is rising and to do the opposite of the market during declines, once took nearly two years to recover
from a 20 percent drawdown. Are you prepared to endure that in order to make returns of more than 20 percent? Here's an
even tougher example of the extraordinary patience required of investors: In 1973 and 1974, the S&P 500 declined by 44.9
percent. The index eventually regained its pre-decline level. But it took 66 months for some investors just to break even. Unless
you are sure you'd stick with a strategy through the longest historical drawdown for which you have data, don't embark on that
strategy.
9. Unless you are absolutely committed to being a market timer, use both timing and buy-and-hold.
This gives you two non-correlated approaches that will have differing results in any given period. Over long periods, carefully
chosen investments in similar assets may generate similar returns with buy-and-hold and market timing. But in the meantime, the
average of the two may give you lower losses, less risk and (perhaps most important) less anxiety than either market timing or
buy-and-hold alone. This combination may be more appealing to many people than the peaks and valleys of each approach
separately. (See "The Ultimate Investment Combination.")
10. Make sure you understand in advance the realities of market timing.
And make sure you are prepared for them. I cannot emphasize this point too much, so I hope you'll read the following
overview. If you invest money that's governed by timing and you're surprised by everything that happens to your investment,
you will always feel off balance. You'll come to dislike and distrust timing. And even if you follow your system, timing will
produce anxiety for you. That is just the opposite of what it's intended to do.
The realities of market timing
I've never done a study on the topic, but I suspect airline pilots who use market timing have above-average success rates. In
their jobs, they train themselves for trouble. Using simulators, they go through all sorts of disaster situations in advance. Over
and over and over again they practice the worst scenarios, learning to recognize early warning signs of trouble, learning what to
do, learning the capabilities of their aircraft. This is not fun. It is often upsetting and nerve-wracking, even though it's just
practice. But when real trouble hits in the skies, those pilots can go into immediate action, focusing on what must be done
instead of being paralyzed with fear. Simulator training "seems completely real, not a game at all," says one of my clients who is
a veteran pilot. "It gives me more confidence in the actual flying because I have been put through the wringer."
I can't put you in an investment simulator. But in the following discussion, I'll try to give you graphic descriptions of some of the
realities of timing. To get the most value out of this, take the time to imagine each of the following points in enough detail that
you experience it in your gut as well as your brain.
Market timing systems are based on patterns of activity in the past. Every system that you are likely to hear about works well
when it is applied to historical data. If it didn't work historically, you would never hear about it. But patterns change, and the
future is always the great unknown. A system developed for the market patterns of the 1970s, which included a major bear
market that lasted two years, would have saved investors from a big decline. But that wasn't what you needed in the 1980s,
which were characterized by a long bull market. And a system developed to be ideal in the 1980s would not have done well if
it was back-tested in the 1970s. So far in the 1990s, any defensive strategy at all has been more likely to hurt investors than
help them. We can't see into the future any more than anyone else, and we can't know what types of trading patterns our timing
models will have to deal with. So we use timing models developed over all three decades.
If your emotional security depends on understanding what's happening with your investments at any given time, market timing
will be tough. The performance and direction of market timing will often defy your best efforts to understand them. And they'll
defy common sense. Without timing, the movements of the market may seem possible to understand. Every day, innumerable
explanations of every blip are published and broadcast on television, radio, in magazines and newspapers and on the Internet.
Economic and market trends often persist, and thus they seem at least slightly rational. But all that changes when you begin
timing your investments. Unless you developed your timing models yourself and you understand them intimately, or unless you
are the one crunching the numbers every day, you won't know how those systems actually work. You'll be asking yourself to
buy and sell on faith. And the cause of your short-term results may remain a mystery, because timing performance depends on
how your models interact with the patterns of the market. Your results from year to year, quarter to quarter and month to
month may seem random.
Most of us are in the habit of thinking that whatever has just happened will continue happening. But with market timing, that just
isn't so. Performance in the immediate future will not be influenced a bit by that of the immediate past. That means you will
never know what to expect next. To put yourself through a "timing simulator" on this point, imagine you know all the monthly
returns of a particular strategy over a 20-year period in which the strategy was successful. Many of those monthly returns, of
course, will be positive, and a significant number will represent losses. Now imagine that you write each return on a card, put all
the cards in a hat and start drawing the cards at random. And imagine that you start with a pile of poker chips. Whenever you
draw a positive return, you receive more chips. But when your return is negative, you have to give up some of your chips to
"the bank" in this game. If the first half-dozen cards you draw are all positive, you'll feel pretty confident. And you'll expect the
good times to continue. But if you suddenly draw a card representing a loss, your euphoria could vanish quickly. And if the very
first card you draw is a significant loss and you have to give up some of your chips, you'll probably start wondering how much
you really want to play this game. And even though your brain knows that the drawing is all random, if you draw two negative
cards in a row and see your pile of chips disappearing, you may start to feel as if you're on "a negative roll" and you may start
to believe that the next quarter will be like the last one. Yet the next card you draw won't be predictable at all. It's easy to see
all this when you're just playing a game with poker chips. But it's harder in real life. For example, in the third quarter last year,
our conservative Worldwide Balanced strategy, allocated 25 percent each in U.S. stocks and U.S. bonds, international stocks
and international bonds, produced a return of 3.88 percent, very satisfactory for a portfolio invested 50 percent in bonds, in the
third quarter last year. But that was followed by a loss of 3.05 percent in the fourth quarter. Most investors in this strategy, at
least those we know of, stuck with it. But they experienced significant anxiety at the loss and the shock of a sharp reversal in
what they had thought was a positive trend. The same phenomenon happened, with more dramatic numbers, in our more
aggressive strategies. Some investors entered those programs last summer, when the U.S. stock market was sizzling, and then
were shocked to experience big fourth-quarter losses so quickly after they had invested. Some, believing the losses were more
likely to continue than to reverse, bailed out. Had they been willing to endure a little longer, they would have experienced a
small gain in January followed by double-digit gains in February that would have restored much of their 1997 losses. But of
course there was no way to know that in advance.
Most timers won't tell you this, but all market timing systems are "optimized" to fit the past. That means they are based on data
that is carefully selected to "work" at getting in and out of the market at the right times. Think of it through this analogy. Imagine
we were trying to put together an enhanced version of the Standard & Poor's 500 Index, based on the past 30 years. Based
on hindsight, we could probably significantly improve the performance of the index with only a few simple changes. For
instance, we could conveniently "remove" the worst-performing industry of stocks from the index along with any companies that
went bankrupt in the past 30 years. That would remove a good chunk of the "garbage" that dragged down performance in the
past. And to add a dose of positive return, we could triple the weightings in the new index of a few selected stocks, say
Microsoft, Intel and Dell. We'd get a new "index" that in the past would have produced significantly better returns than the real
S&P 500. We might believe we have discovered something valuable. But it doesn't take a rocket scientist to figure out that this
strategy has little chance of producing superior performance over the next 30 years. This simple example makes it easy to see
how you can tinker with past data to produce a "system" that looks good on paper. This practice, called "data-mining," involves
using the benefit of hindsight to study historical data and extract bits and pieces of information that conveniently fit into some
philosophy or some notion of reality. Academic researchers would be quick to tell you that any conclusions you draw from
data-mining are invalid and unreliable guides to the future. But every market timing system is based on some form of
data-mining, or to use another term, some level of "optimization." The only way you can devise a timing model is to figure out
what would have worked in some past period, then apply your findings to other periods. Necessarily, every market timing
model is based on optimization. The problem is that some systems, like the enhanced S&P 500 example, are over-optimized to
the point that they toss out the "garbage of the past" in a way that is unlikely to be reliable in the future. For instance, we
recently looked at a system that had a few "rules" for when to issue a buy signal, and then added a filter saying such a buy could
be issued only during four specific months each year. That system looks wonderful on paper because it throws out the
unproductive buys in the past from the other eight calendar months. There's no ironclad rule for determining which systems are
robust, or appropriately optimized, and which are over-optimized. But in general terms, look for simpler systems instead of
more complex ones. A simpler system is less likely than a very complex one to produce extraordinary hypothetical returns. But
the simpler system is more likely to behave as you would expect.
To be a successful investor, you need a long-term perspective and the ability to ignore short-term movements as essentially
"noise." This may be relatively easy for buy-and-hold investors. But market timing will draw you into the process and require
you to focus on the short term. You'll not only have to track short-term movements, you'll have to act on them. And then you'll
have to immediately ignore them. Sometimes that's not easy, believe me. In real life, smart people often take a final "gut check"
of their feelings before they make any major move. But when you're following a mechanical strategy, you have to eliminate this
common-sense step and simply take action. This can be tough to do.
You will have long periods when you will underperform the market or outperform it. You'll need to widen your concept of
normal, expected activity to include being in the market when it's going down and out of the market when it's going up.
Sometimes you'll earn less than money-market-fund rates. And if you use timing to take short positions, sometimes you will
lose money when other people are making it. Can you accept that as part of the normal course of events in your investing life?
If not, don't invest in such a strategy.
Even a great timing system may give you bum results. This should be obvious, but market timing adds a layer of complication to
investing, another opportunity to be right or wrong. Your timing model may make all the proper calls about the market, but if
you apply that timing to a fund that does something other than the market, your results will be better or worse than what you
might expect. This is another reason to use multiple systems and multiple assets.
The bottom line for me is that timing is very challenging. I believe that for most investors, the best route to success is to have
somebody else make the actual timing moves for you. You can have it done by a professional. Or you can have a colleague,
friend or family member actually make the trades for you. That way your emotions won't stop you from following the discipline.
You'll be able to go on vacation knowing your system will be followed. Most important, you'll be one step removed from the
emotional hurdles of getting in and out of the market.
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