The stock market has seasonal effects and calendar anomalies, such as the so-called January effect, the Halloween effect, the best six-month strategy and the presidential election cycle. Seasonal and cyclical market-timing strategies challenge the efficient market hypothesis (EMH). Market timing represents a short-term bet against long-term asset-allocation targets, where market timers hope to enhance total portfolio returns via employing tactical moves.
The major objectives of marketing timing are twofold: (a) to avoid large market declines, and (b) to outperform the buy-and-hold strategy. Market timers believe that the safest way to invest is to be out of the market by either being in a short position or risk-free assets during declining periods and investing in high-risk assets during an uptrend. In this sense, the biggest winners are simply the minority that outperformed the universe because the distribution of individual stock performance has been persistently non-normal over the past.
Since market-timing strategies require taking relatively new while generally undiversifiable positions, most active market timers fail. First, market-timing decisions involve the large questions of the valuation of various asset classes. Professional market timers may be skilled enough to overcome the odds by making a correct call, but the market may fail to resolve valuation discrepancies in the short run. Market timers will have to develop views on a broad range of factors to succeed in the competitive investment market, which is almost impossible for short-term investors.
The biggest risk of market timing is perhaps missing out a good time or the best-performing cycles of the market. Despite that profits can be enhanced by occasionally engaging in short-term and tactical deviations, the market may still have its most profitable months. Additionally, timing the market with precision consistently is very challenging. Even if market timers have developed various buy and sell indicators, signals and timing models to predict security price, trading volume and investor sentiment at a given time, no market-timing strategies can tell them in advance when the market will change direction.
Market-timing strategies also call for high portfolio turnover, moving from company to company or from sector to sector to earn high returns. I freely admit there is a small number of talented portfolio managers who have demonstrated outperformance over long periods of time by utilizing high-turnover strategies; however, more often than not, high portfolio turnover impacts the investment quality of portfolios and results in higher transactional brokerage fee costs. For taxable individual investors, high-turnover approaches lead to a higher requirement for investment success to match the after-tax results of buy-and-hold portfolios.
No Market Timing ≠ Passive Investing
In my book “Alternatives Thinker: Endowment Investment Philosophy to Active Portfolio Management”, I did a performance attribution analysis on the 831 portfolios of large educational institutions in the United States. The result proves that the asset-allocation effect dominates the market-timing effect and the security-selection effect combined. With an appropriate asset allocation guideline, investors can keep a long-term perspective and make investment decisions that are associated with their financial situations and unique circumstances. Contrarian investing holds that successful investing requires the regular purchase of the out-of-favor and the sale of the in-favor.
In addition to following a well-thought-out asset allocation framework, having a core investment philosophy is equally important. All investment success requires a common theme that runs through the entire investment process; investment philosophy is a coherent way of thinking about the market, how it works and why it does not work. Superior performance usually results from strong principles and investors’ consistently examining their preferences and sticking to the principles that guide each of their buy and sell decisions. Adhering to a well-designed investment policy in place is also critical, because behavioral finance, which has explored the real human limitations, asserts that investors tend to make irrational decisions about investments at times.
The bottom line is investment process should always be an active one. Sensible investors behave in a disciplined and independent fashion. They start with a careful articulation of reasonable portfolio targets and adopt a long-term-oriented investment strategy. They review their portfolios periodically to make sure their asset allocation is still on track to help meet their respective investment objectives. They always give another thought as their needs change, and they rebalance their portfolios to ensure they have the most appropriate mix of higher or lower risky assets at any point in time. Investors acting in such a manner have the greatest potential to participate in any top-performing day.
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