| Market timing systems are based on patterns of | | | | we were trying to put together an enhanced version |
| activity in the past. Every system that you are likely | | | | of the Standard & Poor's 500 Index, based on |
| to hear about works well when it is applied to | | | | the past 30 years. Based on hindsight, we could |
| historical data. If it didn't work historically, you would | | | | probably significantly improve the performance of the |
| never hear about it. But patterns change, and the | | | | index with only a few simple changes. |
| future is always the great unknown. | | | | For instance, we could conveniently *remove* the |
| A system developed for the market patterns of the | | | | worst-performing industry of stocks from the index |
| 1970s, which included a major bear market that | | | | along with any companies that went bankrupt in the |
| lasted two years, would have saved investors from | | | | past 30 years. That would remove a good chunk of |
| a big decline. But that wasn't what you needed in the | | | | the *garbage* that dragged down performance in |
| 1980s, which were characterized by a long bull | | | | the past. And to add a dose of positive return, we |
| market. And a system developed to be ideal in the | | | | could triple the weightings in the new index of a few |
| 1980s would not have done well if it was back-tested | | | | selected stocks; say Microsoft, Intel and Dell. We'd |
| in the 1970s. So far in the 1990s, any defensive | | | | get a new *index* that in the past would have |
| strategy at all has been more likely to hurt investors | | | | produced significantly better returns than the real |
| than help them. | | | | S&P 500. We might believe we have discovered |
| If your emotional security depends on understanding | | | | something valuable. But it doesn't take a rocket |
| what's happening with your investments at any given | | | | scientist to figure out that this strategy has little |
| time, market timing will be tough. The performance | | | | chance of producing superior performance over the |
| and direction of market timing will often defy your | | | | next 30 years. |
| best efforts to understand them. And they'll defy | | | | This simple example makes it easy to see how you |
| common sense. Without timing, the movements of | | | | can tinker with past data to produce a *system* |
| the market may seem possible to understand. Every | | | | that looks good on paper. This practice, called |
| day, innumerable explanations of every blip are | | | | *data-mining,* involves using the benefit of hindsight |
| published and broadcast on television, radio, in | | | | to study historical data and extract bits and pieces of |
| magazines and newspapers and on the Internet. | | | | information that conveniently fit into some philosophy |
| Economic and market trends often persist, and thus | | | | or some notion of reality. Academic researchers |
| they seem at least slightly rational. But all that | | | | would be quick to tell you that any conclusions you |
| changes when you begin timing your investments. | | | | draw from data-mining are invalid and unreliable guides |
| Unless you developed your timing models yourself | | | | to the future. But every market timing system is |
| and you understand them intimately, or unless you | | | | based on some form of data-mining, or to use |
| are the one crunching the numbers every day, you | | | | another term, some level of *optimization.* The only |
| won't know how those systems actually work. You'll | | | | way you can devise a timing model is to figure out |
| be asking yourself to buy and sell on faith. And the | | | | what would have worked in some past period, then |
| cause of your short-term results may remain a | | | | apply your findings to other periods. |
| mystery, because timing performance depends on | | | | Necessarily, every market timing model is based on |
| how your models interact with the patterns of the | | | | optimization. The problem is that some systems, like |
| market. Your results from year to year, quarter to | | | | the enhanced S&P 500 example, are |
| quarter and month to month may seem random. | | | | over-optimized to the point that they toss out the |
| Most of us are in the habit of thinking that whatever | | | | *garbage of the past* in a way that is unlikely to be |
| has just happened will continue happening. But with | | | | reliable in the future. For instance, we recently looked |
| market timing, that just isn't so. Performance in the | | | | at a system that had a few *rules* for when to |
| immediate future will not be influenced a bit by that | | | | issue a buy signal, and then added a filter saying such |
| of the immediate past. That means you will never | | | | a buy could be issued only during four specific |
| know what to expect next. To put yourself through | | | | months each year. That system looks wonderful on |
| a *timing simulator* on this point, imagine you know | | | | paper because it throws out the unproductive buys in |
| all the monthly returns of a particular strategy over a | | | | the past from the other eight calendar months. |
| 20-year period in which the strategy was successful. | | | | There's no ironclad rule for determining which |
| Many of those monthly returns, of course, will be | | | | systems are robust, or appropriately optimized, and |
| positive, and a significant number will represent losses. | | | | which are over-optimized. But in general terms, look |
| Now imagine that you write each return on a card, | | | | for simpler systems instead of more complex ones. |
| put all the cards in a hat and start drawing the cards | | | | A simpler system is less likely than a very complex |
| at random. And imagine that you start with a pile of | | | | one to produce extraordinary hypothetical returns. |
| poker chips. Whenever you draw a positive return, | | | | But the simpler system is more likely to behave as |
| you receive more chips. But when your return is | | | | you would expect. |
| negative, you have to give up some of your chips to | | | | To be a successful investor, you need a long-term |
| *the bank* in this game. If the first half-dozen cards | | | | perspective and the ability to ignore short-term |
| you draw are all positive, you'll feel pretty confident. | | | | movements as essentially *noise.* This may be |
| And you'll expect the good times to continue. But if | | | | relatively easy for buy-and-hold investors. But market |
| you suddenly draw a card representing a loss, your | | | | timing will draw you into the process and require you |
| euphoria could vanish quickly. | | | | to focus on the short term. You'll not only have to |
| And if the very first card you draw is a significant | | | | track short-term movements, you'll have to act on |
| loss and you have to give up some of your chips, | | | | them. And then you'll have to immediately ignore |
| you'll probably start wondering how much you really | | | | them. Sometimes that's not easy, believe me. In real |
| want to play this game. And even though your brain | | | | life, smart people often take a final *gut check* of |
| knows that the drawing is all random, if you draw | | | | their feelings before they make any major move. But |
| two negative cards in a row and see your pile of | | | | when you're following a mechanical strategy, you |
| chips disappearing, you may start to feel as if you're | | | | have to eliminate this common-sense step and simply |
| on *a negative roll* and you may start to believe | | | | take action. This can be tough to do. |
| that the next quarter will be like the last one. Yet the | | | | You will have long periods when you will |
| next card you draw won't be predictable at all. It's | | | | underperform the market or outperform it. You'll |
| easy to see all this when you're just playing a game | | | | need to widen your concept of normal, expected |
| with poker chips. But it's harder in real life. | | | | activity to include being in the market when it's going |
| For example, in the fourth quarter of 2002, our | | | | down and out of the market when it's going up. |
| Nasdaq portfolio strategy, with an objective to | | | | Sometimes you'll earn less than money-market-fund |
| outperform the Nasdaq 100 Index, produced a return | | | | rates. And if you use timing to take short positions, |
| of 5.9 percent, very satisfactory for a portfolio | | | | sometimes you will lose money when other people |
| invested in technology funds only. But that was | | | | are making it. Can you accept that as part of the |
| followed by a loss of 7.8 percent in the first quarter | | | | normal course of events in your investing life? If not, |
| of 2003. Most investors in this strategy, at least | | | | don't invest in such a strategy. |
| those we know of, stuck with it. But they | | | | Even a great timing system may give you bad |
| experienced significant anxiety at the loss and the | | | | results. This should be obvious, but market timing |
| shock of a sharp reversal in what they had thought | | | | adds a layer of complication to investing, another |
| was a positive trend. The same phenomenon | | | | opportunity to be right or wrong. Your timing model |
| happened, with more dramatic numbers, in our more | | | | may make all the proper calls about the market, but |
| aggressive strategies. | | | | if you apply that timing to a fund that does |
| Some investors entered those portfolios in the | | | | something other than the market, your results will be |
| winter of 2002, and then were shocked to | | | | better or worse than what you might expect. This is |
| experience big first-quarter losses so quickly after | | | | a reason to use funds that correlate well you're your |
| they had invested. Some, believing the losses were | | | | system. |
| more likely to continue than to reverse, bailed out. | | | | The bottom line for me is that timing is very |
| Had they been willing to endure a little longer, they | | | | challenging. I believe that for most investors, the best |
| would have experienced double-digit gains during the | | | | route to success is to have somebody else make |
| remainder of 2003 that would have restored and | | | | the actual timing moves for you. You can have it |
| exceeded all of their losses. But of course there was | | | | done by a professional. Or you can have a colleague, |
| no way to know that in advance. | | | | friend or family member actually make the trades for |
| Most timers won't tell you this, but all market timing | | | | you. That way your emotions won't stop you from |
| systems are *optimized* to fit the past. That means | | | | following the discipline. You'll be able to go on |
| they are based on data that is carefully selected to | | | | vacation knowing your system will be followed. Most |
| *work* at getting in and out of the market at the | | | | important, you'll be one step removed from the |
| right times. Think of it through this analogy. Imagine | | | | emotional hurdles of getting in and out of the market. |