Session 30 (of 42): Market Timing - Setting the Table

0:00 Hi, welcome back. In this session, I'd like to turn to something we haven't talked about so far in this class. As you look at the journey we've come through, we looked at technical analysis and charting. We looked at value investing, growth investing, arbitrage, trading on information. But in every one of these, we focused in individual stocks, individual investments. In this session, I want to focus on market timing. Why so many people are drawn to it and why it's so difficult to succeed. I call it the impossible dream drawing on a Broadway show. But it is a dream that almost every investor has. I'd be lying if I said I don't try to time markets. In fact, anybody who claims that they never time markets is lying because the draw of market timing is so great that everybody at some point in time in their investing life does a wee bit of market timing. So let's see where market timing fits in the portfolio process.

1:04 You remember I talked about the three steps of devising a portfolio. The first is asset allocation. deciding what percentage of your wealth goes into stocks and bonds and real assets and you can expand that out into geographies and sectors. The broad asset allocation decision. The second step is what we call stock selection, investment selection. Which stocks, which bonds, which real real assets should you hold? And the third part is execution. Market timing is all about the asset allocation part of the portfolio management process. And here's how it plays out. We talked about how as investors based on our risk aversion, we make a judgment of how much money to put into different asset classes. So let's say that you're in your mid30s and you have a long time horizon. You're willing to take risk and you say I put my 60% of my money in stocks, 30% in bonds, and 10% in real estate. Fair enough. That is an asset allocation bas based on your risk aversion, your age, and what you what your liquidity needs are. Here's where market timing comes in. Let's assume you think markets are overpriced.

2:14 In particular, stocks are overpriced, but you believe bonds are underpriced. Here's what you would do. Rather than put 60% of your money into stocks, you might put only 40 or 20 or even 0% and increase the amount you have in bonds. So market timing is about moving away from that asset allocation mix that's the right one given your risk aversion but doing it because you think a particular market stocks or bonds or real assets is underpriced or overpriced. Now within each of these broad asset classes you can do further market timing within stocks for instance you can decide US stocks are overpriced but European stocks are underpriced. So what do you do? You overload on European stocks more than you normally own and and underload on US stocks. So market timing is all about changing your asset allocation.

3:08 You're saying why do people try? The reason is very simple. If you can time markets, the amount of returns you can make will vastly be vastly greater than the returns you will make by picking individual stocks. In 1986 article that drew a lot of attention, a group of researchers looked at what percentage of the variation in quarterly performance across active investors is explained by asset allocation 94%. Most of the differences came not from the individual stocks they picked but from the allocated how much money they decide to put in the stock market. A later study looked at mutual funds and pension funds and concluded that about 40% of the difference in returns came from their asset allocation decisions.

3:52 Asset allocation has a disproportionate effect on your overall returns. So over the last 20 years, you had 90% of your money and you're a US investor, you 90% of your money in T- bills or T- bonds, you would have significantly underperformed the market even though you might have picked the the best bonds during that period. Now, if you dig a little deeper and look further at what what draws us to market timing, here are some very simple statistics as to why you and I are going to be tempted by market timing. You know, when you watch the stock market in across time and you have good years and bad years, good days and bad days, good weeks and bad weeks.

4:32 Let's play a little experiment. Let's assume that you could stay out of the bad days, the bad weeks or the bad years. your returns are going to be much much greater than somebody who couldn't do that, right? And in hindsight, it's going to look obvious. So, you're going to look back and say, "I knew that crash was coming." Notice after every big correction, people claim they knew. I should have got out before. So, in hindsight, it looks like if you time markets, you'd have been you'd be much better off today. And if you dig a little deeper, there will always be indicators that seem to point to that market correction, those bad days, and you say, "If only I'd use those indicators." Those indicators might have been, you know, we and we'll go through a whole series. Might be macroeconomic indicators. They might be technical indicators. They might be feelood indicators, but indicators that told you that a correction was coming.

5:24 In fact, there have been studies that looked at what your returns would look like as an investor if you just avoided the bad days, the bad weeks, or the bad years. One study looked at what would happen if you avoided the 10 worst days of the year, concluded you'd almost double your returns. In 1992, Schilling Schiller Schilling examined the effect of on your annual returns of being able to stay out of the market during bad months, not just bad days, bad months.

5:52 And he concluded that an investor who would have missed the 50 weakest months between 46 and 91 would almost again double their returns. Other studies reinforce this findings. Staying out of the worst days, the worst weeks, the worst months would clearly have this supercharging effect on returns. And if you look back in time and you think about the bubbles, the dot bubble, the 2008 correction, you say, "If only I'd stayed out of that bubble, look how much better off I'd have been." That is the draw of market timing. If only if only if only becomes the the the the recurring thing.

6:31 But there's a cost, right? We talked about the 10 worst days. But one of the things about markets, it's intero interspersed between the worst days is often some of the best days in the market. So as you try to miss the worst days of the market, what if you start missing the best days? And it turns out that if you miss the 10 best days of the market, you can have your return. So here's the challenge. In trying to miss the worst days in the market, are you also missing the best days? In trying to miss the worst months, are you also missing the best months?

7:02 So it turns out that and in fact that's the it gives rise to the thing it's better to spend time in the market than timing the market because many people in trying to time the market end up being out of the market. Now, it goes without saying that if you try to time the market, you're going to turn over your portfolio a lot more, right? You got to sell things and buy things, that's going to increase your transactions cost. Often, you're trading much more than somebody who doesn't do market timing. And if you trade, and we saw that in earlier session on taxes, you're also going to increase your tax libraries. If you think markets are overpriced today and you sell all your stocks and even if you get the timing right, remember when you sell all your stocks, assuming that you've held them for a while, you're going to have tax liabilities that come due when you sell the stock. So that's the trade-off you face. There's a benefit, there's a cost.

7:53 We look at whether the net effect pays off for people, but that's what drives the desired time markets. Now, we talked a lot about timing in the stock market. You can time the bond market as well, right? How does it what form does this take? When you talk about the direction of interest rates that interest rates are going to come down over the next two or three or four years, especially long-term rates, you're telling me bonds are a good place to be because when interest rates come down, bond prices go up. Conversely, we think interest rates are going to go up. Bond prices are going to go down, especially the long-term bonds.

8:28 Timing in the real estate market, we all do it, right? You own a house which you bought in a particular year. You say, "If only I had bought it three years earlier or 5 years earlier, I would have been much better off." If you bought when the market was high and with collectibles and other assets, this has become a recurring theme. You take something like Bitcoin, trading at close to $100,000 when I'm doing this session right now, and you say, "If only I'd put my money in Bitcoin 10 years ago rather than stocks or bonds, think of how much wealthier I'd have been."

9:03 Hindsight is 2020 and looking back in time, it looks like we could have made a lot more money by timing these markets. But what we're missing there is the shifting fundamentals that at that point in time in 2014, you didn't know what was coming. And if you think about your cho choices then, you could have made some bad choices based on looking at the things you looked at. Cycles are unpredictable. Transaction costs are very high. But basically people try to time markets because the payoff looks so high.

9:37 Now in the next few sessions we're going to talk about how people try to time markets. Let me at least list out the choices. There are people who use non-financial indicators. You think what does that mean? That they're indicators that don't show up in the numbers and we'll talk about a few. There are of course technical indicators. We talked about these in the context of trading individual stocks charts trading volume. technical indicators that might tell you where the overall market is going.

10:04 There's a whole group of indicators that I call mean reversion indicators where you invest in something because you think things are going to revert back to the way they used to be. Mean remember the example I gave with interest rates just a couple of minutes ago. How do people decide that interest rates are going to go up or down? They often based on what interest rates have been historically between in the last decade for instance the rates were low 2% 2 and a half% 3% there were people who were convinced rates would go up why not because of any fundamental analysis but because they remember to time when rates were five or 6% that they've got to go back higher there are people who try to time markets using macroeconomic indicators and at its basis you can see that makes sense after all markets reflect economy So if I can forecast what the economy is going to do that's going to strengthen or weaken I should be able to make money out in the market. Maybe maybe not. And finally we talked about valuation in earlier in earlier sessions as a basis for deciding what stocks to buy undervalued versus overvalued. I'm going to argue that you can bring in the same tools of valuation to markets to do an intrinsic valuation of all stocks to decide whether stocks collectively are cheap or expensive, whether interest rates are going to decline or increase and whether real assets are headed up or down. So there's a lot on our table on the table. We look at the variety of choices and why after looking even at the variety we may decide not to time markets. So in summary, everybody tries to time markets. Very few people succeed.

11:44 We look at what makes market timing difficult in the aggregate, but it's something to bring into your arsenal when you think about different investment philosophies. I hope you found the session useful and I thank you very much for listening.