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The Realities Of Market Timing

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  • Robert van Delden
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      Article Title: The Realities Of Market Timing
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      The Realities Of Market Timing
      Copyright � Robert van Delden
      FundSpectrum Group

      Market timing systems are based on patterns of activity in the
      past. Every system that you are likely to hear about works well
      when it is applied to historical data. If it didn�t work
      historically, you would never hear about it. But patterns change,
      and the future is always the great unknown. A system developed
      for the market patterns of the 1970s, which included a major
      bear market that lasted two years, would have saved investors
      from a big decline. But that wasn�t what you needed in the
      1980s, which were characterized by a long bull market. And a
      system developed to be ideal in the 1980s would not have done
      well if it was back-tested in the 1970s. So far in the 1990s,
      any defensive strategy at all has been more likely to hurt
      investors than help them.

      If your emotional security depends on understanding what�s
      happening with your investments at any given time, market timing
      will be tough. The performance and direction of market timing
      will often defy your best efforts to understand them. And
      they�ll defy common sense. Without timing, the movements of the
      market may seem possible to understand. Every day, innumerable
      explanations of every blip are published and broadcast on
      television, radio, in magazines and newspapers and on the
      Internet. Economic and market trends often persist, and thus
      they seem at least slightly rational. But all that changes when
      you begin timing your investments. Unless you developed your
      timing models yourself and you understand them intimately, or
      unless you are the one crunching the numbers every day, you
      won�t know how those systems actually work. You�ll be asking
      yourself to buy and sell on faith. And the cause of your
      short-term results may remain a mystery, because timing
      performance depends on how your models interact with the
      patterns of the market. Your results from year to year,
      quarter to quarter and month to month may seem random.

      Most of us are in the habit of thinking that whatever has just
      happened will continue happening. But with market timing, that
      just isn�t so. Performance in the immediate future will not be
      influenced a bit by that of the immediate past. That means you
      will never know what to expect next. To put yourself through a
      "timing simulator" on this point, imagine you know all the
      monthly returns of a particular strategy over a 20-year period
      in which the strategy was successful. Many of those monthly
      returns, of course, will be positive, and a significant number
      will represent losses. Now imagine that you write each return
      on a card, put all the cards in a hat and start drawing the
      cards at random. And imagine that you start with a pile of poker
      chips. Whenever you draw a positive return, you receive more
      chips. But when your return is negative, you have to give up
      some of your chips to "the bank" in this game. If the first
      half-dozen cards you draw are all positive, you�ll feel pretty
      confident. And you�ll expect the good times to continue. But
      if you suddenly draw a card representing a loss, your euphoria
      could vanish quickly. And if the very first card you draw is a
      significant loss and you have to give up some of your chips,
      you�ll probably start wondering how much you really want to play
      this game. And even though your brain knows that the drawing is
      all random, if you draw two negative cards in a row and see your
      pile of chips disappearing, you may start to feel as if you�re
      on "a negative roll" and you may start to believe that the next
      quarter will be like the last one. Yet the next card you draw
      won�t be predictable at all. It�s easy to see all this when
      you�re just playing a game with poker chips. But it�s harder
      in real life. For example, in the fourth quarter of 2002, our
      Nasdaq portfolio strategy, with an objective to outperform the
      Nasdaq 100 Index, produced a return of 5.9 percent, very
      satisfactory for a portfolio invested in technology funds only.
      But that was followed by a loss of 7.8 percent in the first
      quarter of 2003. Most investors in this strategy, at least those
      we know of, stuck with it. But they experienced significant
      anxiety at the loss and the shock of a sharp reversal in what
      they had thought was a positive trend. The same phenomenon
      happened, with more dramatic numbers, in our more aggressive
      strategies. Some investors entered those portfolios in the
      winter of 2002, and then were shocked to experience big
      first-quarter losses so quickly after they had invested. Some,
      believing the losses were more likely to continue than to
      reverse, bailed out. Had they been willing to endure a little
      longer, they would have experienced double-digit gains during
      the remainder of 2003 that would have restored and exceeded all
      of their losses. But of course there was no way to know that in

      Most timers won�t tell you this, but all market timing systems
      are "optimized" to fit the past. That means they are based on
      data that is carefully selected to "work" at getting in and out
      of the market at the right times. Think of it through this
      analogy. Imagine we were trying to put together an enhanced
      version of the Standard & Poor�s 500 Index, based on the past
      30 years. Based on hindsight, we could probably significantly
      improve the performance of the index with only a few simple
      changes. For instance, we could conveniently "remove" the
      worst-performing industry of stocks from the index along with
      any companies that went bankrupt in the past 30 years. That
      would remove a good chunk of the "garbage" that dragged down
      performance in the past. And to add a dose of positive return,
      we could triple the weightings in the new index of a few
      selected stocks; say Microsoft, Intel and Dell. We�d get a new
      "index" that in the past would have produced significantly
      better returns than the real S&P 500. We might believe we have
      discovered something valuable. But it doesn�t take a rocket
      scientist to figure out that this strategy has little chance
      of producing superior performance over the next 30 years. This
      simple example makes it easy to see how you can tinker with
      past data to produce a "system" that looks good on paper. This
      practice, called "data-mining," involves using the benefit of
      hindsight to study historical data and extract bits and pieces
      of information that conveniently fit into some philosophy or
      some notion of reality. Academic researchers would be quick to
      tell you that any conclusions you draw from data-mining are
      invalid and unreliable guides to the future. But every market
      timing system is based on some form of data-mining, or to use
      another term, some level of "optimization." The only way you can
      devise a timing model is to figure out what would have worked
      in some past period, then apply your findings to other periods.
      Necessarily, every market timing model is based on optimization.
      The problem is that some systems, like the enhanced S&P 500
      example, are over-optimized to the point that they toss out the
      "garbage of the past" in a way that is unlikely to be reliable
      in the future. For instance, we recently looked at a system that
      had a few "rules" for when to issue a buy signal, and then added
      a filter saying such a buy could be issued only during four
      specific months each year. That system looks wonderful on paper
      because it throws out the unproductive buys in the past from
      the other eight calendar months. There�s no ironclad rule for
      determining which systems are robust, or appropriately optimized,
      and which are over-optimized. But in general terms, look for
      simpler systems instead of more complex ones. A simpler system
      is less likely than a very complex one to produce extraordinary
      hypothetical returns. But the simpler system is more likely to
      behave as you would expect.

      To be a successful investor, you need a long-term perspective
      and the ability to ignore short-term movements as essentially
      "noise." This may be relatively easy for buy-and-hold investors.
      But market timing will draw you into the process and require
      you to focus on the short term. You�ll not only have to track
      short-term movements, you�ll have to act on them. And then
      you�ll have to immediately ignore them. Sometimes that�s not
      easy, believe me. In real life, smart people often take a final
      "gut check" of their feelings before they make any major move.
      But when you�re following a mechanical strategy, you have to
      eliminate this common-sense step and simply take action. This
      can be tough to do.

      You will have long periods when you will underperform the market
      or outperform it. You�ll need to widen your concept of normal,
      expected activity to include being in the market when it�s going
      down and out of the market when it�s going up. Sometimes you�ll
      earn less than money-market-fund rates. And if you use timing to
      take short positions, sometimes you will lose money when other
      people are making it. Can you accept that as part of the normal
      course of events in your investing life? If not, don�t invest
      in such a strategy.

      Even a great timing system may give you bad results. This should
      be obvious, but market timing adds a layer of complication to
      investing, another opportunity to be right or wrong. Your timing
      model may make all the proper calls about the market, but if you
      apply that timing to a fund that does something other than the
      market, your results will be better or worse than what you might
      expect. This is a reason to use funds that correlate well you�re
      your system.

      The bottom line for me is that timing is very challenging. I
      believe that for most investors, the best route to success is to
      have somebody else make the actual timing moves for you. You can
      have it done by a professional. Or you can have a colleague,
      friend or family member actually make the trades for you. That
      way your emotions won�t stop you from following the discipline.
      You�ll be able to go on vacation knowing your system will be
      followed. Most important, you�ll be one step removed from the
      emotional hurdles of getting in and out of the market.

      Resource Box:
      Robert van Delden has been managing the FundSpectrum Group since
      1998, whose objective it is to help individual investors to
      increase their investment returns using low risk Market Timing
      strategies.. More details can be found on our membership web
      site: http://www.fundspectrum.com

      Posted: Fri Oct 1 03:00:30 EDT 2004

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