By Wealth Foundations

Popularity of Market Timing resurges due to GFC

We might sound like old fuddy-duddies for continuing to propose a strategic (or fixed) asset allocation approach over one that involves jumping in out of the market to avoid falls in portfolio value. But the benefits of strategic asset allocation still stack up even after allowing for the recent turmoil of the GFC.

Our basic premise is to adopt well researched and academically accepted strategies and to continue to use them until we find a superior alternative. At this point, there is no new academic evidence that we are aware of to suggest that market timing can reliably overcome the additional costs it creates.

In 2008, we back tested historical data to compare the risk and return outcomes of two approaches – a) one based on a strategic allocation of assets (in this case, Cash or Shares) and b) one based on switching between Cash and Shares according to recent performance. The conclusion of that analysis was clearly in favour of the strategic asset allocation approach. We’ve updated the assessment to see how things look today after the impact of the GFC.

Many pundits have condemned a strategic buy and hold approach over recent times, claiming the world has changed and it no longer works. Much of this commentary is from those who are looking for something to blame for the lower returns that have accompanied one of the worst downturns in recent history. Unfortunately, the critics’ usual alternative is to advocate a more active approach involving market timing and specific stock selection. Yet these approaches have failed to deliver in the past and are likely to continue to be inferior to a well designed strategic asset allocation approach.

Even successful market timing didn’t pay off

Our back tested assessment is based on the following assumptions:

1) For simplicity, we assume there are only two asset classes to choose from: Australian Shares and Cash;

2) For the market timer, we assume that they rely heavily on recent past performance. We acknowledge that there are alternative approaches to market timing that aim to pre-empt market moves, but essentially most investors are heavily influenced by recent performance.

We also assume that market timing investors are willing to shift from Shares to Cash when the performance for Cash exceeds the performance for Shares over the past 12 months (and vice versa). We consider that most market timers have a longer term view than that of a market trader and will therefore hold any position for a minimum of three months and will implement each decision after three months of confirming data.

3) The strategic investor holds a portfolio with a combination of 15% Cash exposure and 85% Shares exposure (as per our original analysis). The portfolio is re-balanced on an annual basis which allows the risk exposure to be maintained over time. It means selling part of the better performing asset class and reinvesting in the poorer performer (i.e. a buy low, sell high approach).

We analysed data since January 1980 (to February 2012) and the results are shown in the table and chart below:

The results reveal that the strategic investor achieved approximately the same return, but with lower volatility, as the market timer. And, this is before taking into consideration the additional costs of implementing the market timing strategy (i.e. via transaction costs, buy/sell spread costs and capital gains tax).

While, the strategic investor does not avoid capital gains tax, its deferral adds significantly to after-tax returns. Based on the above assessment, the early crystallisation of capital gains reduces the return of the market timer by an extra 1.0% per annum over the period. That’s a significant additional cost.

Surely, the market timer benefited throughout the GFC?

The chart below reveals that the market timer did benefit from being in cash throughout the GFC (making a fortuitous switch to Cash in August 2008).

However, while the market timer missed the GFC downturn they also failed to buy back in to shares at lower prices. So, even with “successful” timing they’ve ended up no better off than the strategic investor (before costs).

Market Timing is unlikely to pay off

From our perspective, market timing is a riskier proposition than a strategic asset allocation approach. The market timer is burdened with known additional costs, which means they have to be able to generate reliable additional return. This is much harder than it appears over the long term.

The appeal of market timing is obvious. The strategy gains most support when markets decline, yet there is no academic research that shows that it can reliably outperform. That doesn’t mean that we believe the timing of your investments has no impact on your affairs – obviously it does. We simply believe there are much smarter and more reliable ways to achieve your long term outcomes.

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Wealth Foundations (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.