Invest Skeptically

In times like these when there is so much uncertainty about asset prices and such a heightened sense that something’s gotta give, we naturally start thinking about mixing things up. Should we change the allocation of stocks versus bonds? Bond prices have already begun to fall (creating higher yields). Move more money into cash? Change the country mix? Sector mix? There is no easy conclusion to this very strategic — and tactical — topic.

In a traditional buy-and-hold asset allocation strategy you would ride out the bad times and periodically rebalance your portfolio back to your preferred/target/”optimal” asset mix. But another technique is to be more tactical about your asset mix and adjust it depending on your view. Now to market timing.

Larry MacDonald at Canadian Business Online writes about market timing and cites a Crestmont Research study that discusses what would happen if you missed the 10 worst days in the stock market. “On that basis, the S&P 500 would have gained 5.9% instead of losing 24.2% in 2002. In 2003, the return from missing the 10 worse days would have been 59% versus the 26.4% rise in the S&P 500.”

This is a different perspective from the buy-and-hold crowd. One RBC Investments flyer I’ve read shows that missing the 10 best days in the S&P/TSX Composite, over a 10-year period, ending December 31, 2004, would cut your average annual return from 10.1% to 5.8%. John Heinzl at the Globe and Mail (June 6, 2007) cites a Birinyi Associates study that points to a similar conclusion and generally thinks market timing is a bad idea.

Nonetheless, in A Quantitative Approach to Tactical Asset Allocation, published in, The Journal of Wealth Management (Spring 2007), Mebane T. Faber discusses a very simple trend following model (buy stocks when prices go above the 10-month moving average and sell when they go below) that appears to generate higher returns with lower risk than simply buying and holding the S&P 500 over a long period of time. Faber also confirms these findings for other global equity indices and other asset classes. The model works by avoiding large losses and large gains but increasing the frequency of smaller losses and gains.

While Faber’s approach sounds tempting for its simplicity, the tests on the S&P 500 resulted in the market timing strategy underperforming the index 40% of the time!

The conclusion: investment strategy and managing your own emotions are hard.

Epilogue: the DJIA, S&P 500, and NASDAQ crossed above their 200-day moving averages in summer of 2006, and the S&P/TSX Composite and the Russell 2000 did so in fall of 2006. None of these indices have yet come back down.