“What’s the difference between ‘buy low, sell high’ and ‘timing the market’?”

That was a question posed by a friend recently. He said that he had been advised to “take some wins off the table and invest in under-appreciated assets”. He went on to say, “which sounds like trying to time the market.”

He may be getting good advice, but he is right to be skeptical. 

Market Timing

To explore his question further though, we may want to agree upon the definition of “market timing”. According to Investopedia, “Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods such as technical indicators or economic data.”

In other words, market timers think they can predict future market movement based on information available to everyone. One category of market timers are chart readers, also known as technical analysts. Technicians can seemingly explain virtually all price movements of individual stocks and markets by recognizing shapes such as cups, diamonds, and wedges formed by graphing prices on stock charts such as seen in Exhibit 1.

Weekly Stock Chart of Netflix (NFLX)

In fact, technical analysts are great at finding shapes on charts. There are literally dozens of these “indicators” that they can supposedly divine buy or sell points from. The problem is that many of the shapes offer conflicting predictions. While one reader may see a bullish cup and handle pattern, another may see a bearish rising wedge. Remember that the next time an analyst on your favorite business channel tries to show one of these patterns that preceded a recent price movement. This is known as cherry picking.

Cherry picking is the practice of looking for information that supports a particular point of view while ignoring anything that doesn’t. If you want to see other examples of cherry picked data, watch a few political ads this election season.

At a firm I once worked, they had a room devoted to storing and displaying old stock charts going back for decades. The person that oversaw that room was a technical analyst and also a popular speaker. He was charming, witty, and adept at finding past patterns that seemed to offer insight into the direction of the markets.

He was so convincing that they ultimately gave him a mutual fund to manage. It turned out that he was much more skilled at mining data that supported his opinions than he was at seeing information that gave him an edge in making prescient investment decisions. After a couple of years of under-performance, he was relieved of his role as a fund manager. Then, as is all too common, the fund was merged into a better performing one to effectively erase the poor track record.

He landed on his feet, however, going right back to his job of giving presentations and going on the business channels to peddle his bowl of cherries and BS (not an acronym for Buy Sell). 

Buy Low, Sell High

While all successful investing involves recouping more than you paid originally, having a disciplined “buy low, sell high” process just relies on being able to look back and do some simple arithmetic. In order for the process to be effective, however, there must be a plan in place to offer a structure to be disciplined toward.

Instead of trying to guess where a stock or the market is headed, you first must determine what your plan is for allocating your assets. Your plan could be fairly complex, defining how much you should allocate to different types of investments (i.e. large vs small company stocks, foreign vs domestic, government vs corporate bonds, etc) coupled with the levels above and below your target amounts that you will buy or sell.

Or, you could also do it very simply. Say, for example, you determine that you can only sleep soundly at night if no more than half of your 401(k) is invested in the stock market and the other half is safely tucked away in your mattress. Your initial allocation may be 50% in a broadly diversified stock mutual fund and the other 50% in money market (mattresses are not approved investment options in retirement plans).

If the stock market rises 10% and the cash stays the same, the new allocation would be 55% stocks and 45% cash. A disciplined ‘buy low, sell high’ approach would suggest that you sell some of the stocks now that they are relatively higher and put the gains into cash, thus increasing your sleeping aid balance. This asset allocation approach doesn’t prevent occasional losses overall, but it can smooth the volatility of a portfolio that drifts too far one way or the other. 

A Case Study

Warwick Schneller, a researcher at Dimensional Fund Advisors, took an academic approach to seeking evidence of whether market timing adds value over a static asset allocation. He compared an asset allocation that switched back and forth between stocks (S&P 500 Index) and cash (One-Month US Treasury Bills) to a static portfolio that re-balanced regularly. He looked at the 90-year period ending December 2016.

The static portfolio simply re-balanced to a 60% stock and 40% cash allocation each month over that time. The market timing simulation involved randomly assigned months to be in 100% stocks or 100% cash, with the average exposure to stocks remaining at 60% for the tested time frame. For example, one market timing simulation may involve being invested for the first 36 months over each 60-month period, the next may be the last 36 months over the same period, then the middle 36 months, and so forth until 1000 different simulations were modeled.

As seen in Exhibit 2, he found that the hypothetical static portfolio had the same monthly average return as the market timing simulations. However, the static portfolio had a higher annualized compound return because it had less risk than the market timing model. It should also be mentioned that this is all based on hypothetical indices and that in real life there likely would be additional trading and tax costs that would favor a disciplined static strategy even more.

60/40 Static Portfolio vs. Market Timing

As for my friend’s question about market timing, a disciplined asset allocation plan that relies upon actual market results to inform when and what to buy low or sell high is fundamentally different from market timing approaches that seek to guess when to do so. A question I should pose to him is if his portfolio is inline with his plan? Or even if he has a plan?

If your answer to either of those questions is “no”, maybe its time for you to get in touch.

[1] The sample period is January 1926–December 2016. S&P 500 Index from January 1926–December 1989 are from Ibbotson data, courtesy of Stocks, Bonds and Inflation Yearbook, Ibbotson Associates. January 1990–December 2016 data obtained from Standard and Poor’s Index Services Group. One-Month US Treasury Bills from Morningstar. The static allocation re-balances to target weights at the end of each month. Results for market timing are the average for 1,000 timing outcomes. Each market timing run randomly holds all equity 60% of the time and all fixed income 40% of the time.

RISKS

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

Results shown herein are not representative of actual strategies or accounts, do not reflect costs and fees associated with an actual investment and are no guarantee of future results. Market timing strategies typically seek to allocate between equity and fixed income based on predictions or changes in market or economic outlook. The 1,000 market timing outcomes represented above do not reflect asset allocation decisions a market timing manager might have made due to economic or market factors. Results attained by bootstrapping samples may vary for each use and over time.