Does Market Timing Ever Work?

TL;DR

Market timing can sometimes add value, but the evidence presented does not support it as a reliable investment strategy. An AQR valuation-based strategy added value from 1900 through 2015 yet underperformed from 1958 through 2015, while missing the S&P/TSX Composite’s 15 best days from 1977 through 2018 reduced annualized returns from 9.72% to 7.44%. Read on to understand why valuations, momentum, and confirmation bias make timing so difficult.

Transcript

• Even the most rational index investors might catch themselves wondering if they should sell some of their equities, or delay investing new cash because of expected market volatility, or reports of record high stock prices. And if the market does happen to drop, our brains will allow us to believe that we were right, which might increase the futur... Read More

Key Insights

• 💄 There is historical data suggesting a relationship between current market valuations and future returns, but this data has limitations and is not reliable for making investment decisions.
• 🛀 AQR's study on market timing strategies showed mixed results, with the strategy underperforming in certain time periods.
• 🗯️ Market timing requires accurately predicting both the right time to get out of and back into the market, which is challenging even with reliable forecasting metrics.
• ↩️ Trading costs and taxes incurred from frequent buying and selling can negatively impact returns.
• 🎵 Market timing is not a widely successful or consistent strategy, as noted by industry experts like John Bogle.
• 🍹 While dollar cost averaging can alleviate concerns about market timing, it is still statistically suboptimal compared to investing a lump sum.
• 💄 Feelings of uncertainty are not a reliable basis for making market timing decisions.

Questions & Answers

Q: Does market timing ever work?

Market timing can work during some periods, but the results are not consistent enough to establish it as a reliable strategy. An AQR valuation-based strategy added value over the full 1900–2015 sample but underperformed from 1958 through 2015.

Q: What is market timing?

Market timing means changing when or how much you invest based on expected market movements. Examples include selling equities or delaying the investment of new cash because volatility is expected or stock prices appear unusually high.

Q: Can the Shiller CAPE reliably predict future stock returns?

The Shiller CAPE is described as the most reliable available metric for forecasting future returns, and high valuations have often preceded lower returns. However, its apparent predictive power weakens substantially when stocks are compared only with information an investor would actually have had at the time.

Q: Why does hindsight bias weaken valuation-based market timing evidence?

Sorting stocks by valuation relative to an entire historical dataset uses future valuations that a real investor could not know. When the AQR analysis instead used only the preceding 60 years of data at each quarter, the relationship between expensive stocks and lower future returns became much weaker.

Q: What did AQR’s “Market Timing, Sin a Little” study find?

AQR tested a strategy that adjusted stock exposure according to valuations using data from 1900 through 2015. It added value across the full sample but underperformed from 1958 through 2015, when stocks were generally expensive relative to their past and the strategy remained under-invested for much of the period.

Q: Why can stocks remain expensive for years or decades?

Valuations can drift higher or lower for years or decades, making it hard to classify the current market confidently without hindsight. In the study, stocks were generally cheap relative to their past from 1900 through 1957 and generally expensive from 1958 through 2015.

Q: How does momentum complicate market timing?

Stocks that have risen in price tend to continue along that trajectory for some time, a pattern described as momentum. Selling when rising prices make stocks look expensive through measures such as the Shiller CAPE therefore means betting against that momentum.

Q: How much can missing the market’s best days affect returns?

The S&P/TSX Composite returned 9.72% annually from 1977 through 2018. Missing the single best trading day lowered that return to 9.48%, while missing the 15 best days lowered it to 7.44%, illustrating the cost of being out of the market at critical moments.

Summary & Key Takeaways

• Market timing is the act of trying to predict the future movement of the stock market based on various indicators, such as valuations.

• Historical data suggests that when stocks are expensive relative to the past, future returns tend to be lower. However, this data has a hindsight bias and cannot be relied upon for accurate predictions.

• A study by AQR tested a market timing strategy based on valuations from 1900 to 2015. While the strategy added value to returns for the full sample, it underperformed from 1958 to 2015.

• Dollar cost averaging, while a form of market timing, statistically provides suboptimal results compared to investing a lump sum.