Executive Summary
Once again the charge of being a “market timer” is being hurled at active portfolio managers in a recent discussion thread initiated by Bob Veres on Financial-Planning.com. The term itself seems to get planners into such a tizzy, though, while the actual definition of what constitutes “market timing” is unclear at best; perhaps a new definition of market timing is in order. To say the least, the most common definition of market timing, the one that implies that market timers are similar to “retail” day-traders willing to take their portfolios to extreme asset allocations based on their very short-term predictions of future market behavior, is badly in need of an upgrade.
EDITOR'S NOTE: This post was written jointly with Ken Solow, Chief Investment Officer for Pinnacle Advisory Group and author of "Buy and Hold is Dead (Again)". You can see more about Ken and his firm at the Pinnacle website, and their blog Echoes From The Pit. Pinnacle Advisory Group currently offers portfolio consulting services for RIAs and planners interested in outsourcing their portfolio management services.
For instance, let’s look at a common version of a transaction that appears to constitute “market timing” in the Veres discussion thread on Financial-Planning.com: a transaction that involves selling an overvalued security (or asset class) in favor of buying an undervalued security or asset class. Since the purchase and sale involves some shift in asset allocation or security selection, and must be executed with some timing, it is implied as market timing. With this particular transaction in mind, though, let’s consider some of the following questions:
1.Is the act of selling an overvalued security or asset class (impliedly one that has a significant possibility for underperformance or price decline) in order to purchase an undervalued security or asset class an activity that is risk reducing or risk increasing?
2.If you instead ignore the valuation implications of overvalued asset classes and simply hold the same static allocation that includes those overvalued investments no matter what, is that activity risk reducing or risk increasing?
3.If you rebalance a buy and hold portfolio by selling the investment that has become overweighted and buying the one that has become underweighted – which also implies that the rising one has become overvalued and the declining one may be undervalued – does that constitute market timing? If it does, then is anyone who rebalances a “buy and hold” portfolio also a market timer? If not, then what’s the difference between rebalancing amongst overweighted and underweighted securities in this question and selling overvalued securities to buy undervalued ones in the prior question?
4.Perhaps the difference is that active valuation decisions require “subjective” decisions; how can you identify when an asset class is overvalued or undervalued? For example, do you think stocks are overvalued at 20x forward operating earnings in a 0% interest rate environment? How about 30x earnings? 40x earnings? 50x earnings? But the point is simple; Is there ANY valuation that would cause you to conclude that, in a particular case, stocks (or some asset class(es)) are overvalued? If you then become willing to sell at SOME point, however extreme, is that “bad” market timing, or is that a risk reducing activity?
5.How much of an improvement in performance do you need in order to make the case that an act of market timing was beneficial to your clients? Is market timing only effective if you avoid ever having declines, as implied by a comment by Veres in the aforementioned thread? What if you “merely” provide 50 or 100 basis points of outperformance? Or 200 basis points? Or 1,000 basis points?
6.If the markets (passive benchmarks) don’t deliver historical average returns because of an extended period of suboptimal performance, then what recourse, other than hoping for higher returns in the future, do you have as a financial planner and an investment professional to help your clients achieve their goals? If your only plan for dealing with an extended period of weak market returns is to buy and hold and hope that better returns arrive before your client runs out of money, does that constitute a plan, or just a hope?
7.If there was no academic evidence that conclusively shows that market timing leads to higher portfolio returns, yet the possibility remains that it could be possible, would it still be worthwhile to attempt to earn them?
If you answer yes to any of the questions above, perhaps saying “I love market timing!” isn't always a bad thing. As Veres' article questions: is it time for planners to consider the practical possibility that some form of “market timing” is required in at least some types of difficult markets, and even more so if they want to have the opportunity to add value to client portfolios above market returns?
This is not to say that active management is easy. It’s simply to make the point that it might be necessary when long-term academically accepted methods of valuation say that markets are expensive and exposed to increased risks of sub-standard returns, which in turn produce results that cannot achieve client goals. Especially since, unfortunately, that appears to be the situation we are in today.
Of course, once the possibility exists that “market timing” might be necessary, even just sometimes at valuation extremes, the conversation should not be about WHO is an ‘evil’ market timer, but instead about HOW to execute such transactions more effectively (or how to outsource them to an investment manager who wishes to do so?). And perhaps to acknowledge that there are ways to shift client portfolios in a constructive manner besides the day-trading all-in-all-out style that is so commonly lambasted as market timing. In other words, we need a better definition of market timing – or at least, a way to more clearly differentiate between “good” and “bad” ‘market timing’.
So what do you think? Does shifting a portfolio in response to market valuation extremes constitute “market timing”? Or is it just prudent management? How much does a portfolio allocation have to change for it to be a “tilt” versus a “market timing” transaction? Do all portfolio changes have an aspect of market timing to them?
How to Meet an Impossible Demand
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These day’s, the term market timing is mostly used pejoratively, much like HUAC used “Communist” in the early 50’s. But let’s get a grip. Just as HUAC lumped progressives, liberals, socialists and do gooders for others under the term “Communist” so is “market timing” given to include much more than my simple, Wikipedia[-based definition assumes. To me, market timing is just making portfolio decisions based on the projection of future market movements. Nothing about value investing here, nothing about portfolio rebalancing, nothing at all concerning individual securities. It’s time to get a grip, folks, or, as the blog suggests, get a new definition which will be acceptable to the great majority. I think it’s a lot more productive to consider the divide between active portfolio management and passive portfolio management. But even in these two gterms there are shades of grey. What constitutes a passive strategy – any old index-based product? How often can an index be rebalanced for it to be passive. Come on guys..let’s talk about something REALLY important, like world peace and how money managers can help promote it. This said, any article which discusses HOW we do our work promotes introspection. This is a good thing, in my view. So…please continue discussing portfolio management, market timing and the like. I’ll just hold my nose, but will be reading every word – Ad Nauseum.
I think the case for market timing must be viewed in terms of the harm being done by lazy advisors assuming they know it all and by their employers being negligent in evaluating imvestment alternatives that can be relied upon to produce reliable positive returns most of the time and avoid downside risks.
1. Half of all the contibutions ever made to tax-deferred retirement savings have benn lost to discounted investments in blue-chip company stock of familiar names which failed or are a shadow of their former selves, tragicly timed target maturity funds approved by Congress as default investments with glidepaths that crashed or will crash, and low-cost large-cap stock index funds that shrunk in the lost decade or at least missed their opportunity to grow.
2. Advisors and fund managers earned more than their clients (investors) over the past decade.
3. The bond rushers who will soon hit a wall.
4. Advisors who never looked back to see their advice did not work because there was no new commission.
At least those trends cost retirement savers $15.7 trillion in just ten years, most of which was the 50% decline of the 1999 year-end assets in just over a year. That was retirement savings’ Achilles’ heel.
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Since “market timing” has been sucessfully branded on methodolgies to change portfolio allocations, advisors are already at a disadvantage. Otherwise, it is just nonsense to put the nomenclature of “market timing” on the acitivity of careful analysis leading to sell, hold, or buy, regardless of when it is done. In all the discussions I have had or read, the idea of holding, which fits into this silly use of “market timing”, is not brought up. After all, when reviewing investments at a specific moment in time, the decision is made to hold, buy, or sell. I certainly hope that advisors and their clients who may be getting less than desired results find resources that assist in more circumspect asset management.
Statistically speaking, the average grade a student receives is a “C”; therefore students should not try for a “B” or an “A” – it is statistically unlikely they will succeed.
There are thousands of restaurants in New York or Chicago, and your odds of finding a better than average meal are statistically unlikely; therefore, you shouldn’t try to identify restaurants that are better than others.
Statistically speaking you can’t time the market and beat a (supposedly) unmanaged index, therefore you should not even try.
Why do we reject the first two arguments, but are supposed to blindly accept the third?
When my clients and I have a 70 year time horizon and can rely on long term averages, then I will buy and hold the market. Until then, I will stick with my diversified allocation and intelligent, “findable”, active managers. My real experience proves, to me at least, that my active models consistently outperform equivalent models using only index funds.