Your Complete Guide to Index Investing with Dan Bortolotti

Why I Have No Faith in Market Timing

2012-05-18T15:00:02+00:00May 17th, 2012|Categories: Behavioral Finance, Research|48 Comments

Earlier this week I described the market timing strategy outlined in Mebane Faber’s book The Ivy Portfolio. I chose not to editorialize too much, preferring instead to simply explain the strategy to readers who may have been unfamiliar with it. So let me make my opinion on this clear now: I do not recommend this strategy or any other form of market timing. I simply don’t believe it will help investors improve their long-term returns.

Let’s start with the obvious point. The performance numbers in Faber’s book (which show a 1.5% boost in returns and much lower volatility since 1973) assume that costs and taxes were zero. But as Larry Swedroe is fond of saying, strategies have no costs, but executing them does. Trading commissions and bid-ask spreads would likely be low with Faber’s strategy, but they will certainly reduce that outperformance. More importantly, in a non-registered account taxes would severely cut into the returns of a timing strategy. (Obviously, in an RRSP this is not an issue.)

Do you have the discipline?

But the real problem with timing strategies is not the costs: it’s behaviour. Faber freely acknowledges that the most important factor in any quantitative strategy is the discipline to pull the trigger, which “is not as easy as it sounds.” The impressive performance of the timing strategy is a backtested result that not only assumes no costs or taxes, but also that the investor executed every trade with robotic, unemotional precision. Very few investors have anything approaching that kind of discipline. Acknowledging this, Faber includes a telling quote from Richard Dennis, creator of the Turtle Trading system:

I always say that you could publish my trading rules in the newspaper and no one would follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80% as good as what we taught our people. What they couldn’t do is give them the confidence to stick to those rules even when things are going bad.

Make no mistake, there are times when all strategies go bad. In fact, the data on Faber’s website shows that the timing model has underperformed in three of the five asset classes since late 2009 (until a couple of months ago, it trailed in all five). Faber’s firm also manages an ETF that uses the strategy, and it is down more than 6% since its inception in November 2010, a period when balanced portfolios delivered positive returns. That’s a short time frame, but you need to ask yourself how patient you will be with a strategy that is significantly lagging the markets. The evidence suggests the patience of active investors tends to last about one to three years.

A good time for timing

Last summer I wrote a series of posts about the Permanent Portfolio, another strategy that promises to protect investors from large drawdowns. Many readers were enamored with the idea of holding 25% in gold, but that’s an easy call after seven years of staggeringly good returns for that asset class. Where were the investors advocating this strategy during the 1980s and 1990s, when gold delivered dismal returns while stocks were compounding at 10% to 12%? The fact is, everyone loves a winner, but few have the resolve to stick with a strategy when it trails the market for several years in a row.

It’s no accident that timing strategies are getting a lot of interest now, with the memory of 2008 still fresh in investors’ minds. Who doesn’t wish they could have avoided that horrendous event? But at some point in the future we’ll have another bull market that lasts three or four years, maybe more. Timing strategies are guaranteed to underperform during prolonged bull markets (as they did throughout the 1990s and in the mid-2000s). That’s when we will see how many investors truly have the discipline to follow them. My sense is this number will be exceedingly small.

About a year ago, Norm Rothery wrote an article about momentum investing for MoneySense, and he summed up his analysis this way:

Perhaps the biggest knock against technical investing is the paucity of investors who have done well following it over many years. Indeed, we have a very hard time finding technical investors with strong, verifiable, multi-year performance records. If you’re out there, please let us know.