In Defense of Market Timing – a study that will shock you!

SmartStops comment :  As we dig up other studies we’ll add to article.  

Missing Best and Worst Days in Stock Market 1984-1998

 The article was originally published in 2008.    

SmartStops  comment  on 08/4/11:    Markets have dropped 9% in last nine days with the whole debt ceiling “show” going on in U.S.  government.   Do you think you needed to have given back your gains?   Think again!

Market timing is the art of making investment decisions using indicators and strategies to observe and determine the direction of prices. Many believe that market timing involves predicting the future, when in reality, the goal of market timing is to participate in periods of price strength and avoid periods of price weakness.

The general investing public has been told that market timing is a high risk proposition. Most of what has been written about the topic focuses on its failure and the risk investors take when trying to time the market. A typical study focuses only on the negative consequences of missing a few particular up days in the market – calculating the negative financial impact of missing those days and concluding that attempting to time the market is foolish. The biggest fallacy with these studies is    in the assumption that attempting to time the market will invariably result in missing some important up days. Why should that assumption be made? Where is their study that supports such an assumption?
Then there is the problem of the missing data. That missing data is the data from the study that clearly shows that the benefits of skipping a few of the worst days more than makes up for the potential drop in performance from missing a similar number of up days. This critical distinction is generally not investigated or is deliberately ignored. Unfortunately these studies misinform the public and encourage investors to neglect their
investments in anticipation of riding those big up days, resulting in the acceptance of substantially more risk than necessary. Let me show you the data from one of the major studies used to frighten investors about market timing. This is only one of many studies that purport to show the hazards of attempting to protect your capital. It’s commonly referred to as the “Black Swan” study because it deals with unusual market events (Black Swans and Market Timing: How Not To Generate Alpha, by Javier Estrada, International Graduate School of Management, Barcelona, Spain).

The period in this study encompasses more than 100 years of daily data on the Dow Jones Industrial Average from December 31, 1899 through December 31, 2006. In total the study examines 29,190 trading days. A $100 investment at the beginning of 1900 turned
into $25,746 by the end 2006, and delivered a mean annual compound return of 5.3%. Here are the most widely publicized parts of the study you are most likely to have seen:
1) Missing the best 10 days reduced the terminal wealth by 65% to $9,008, and the mean annual compound return one percentage point to 4.3%.
2) Missing the best 20 days reduced the terminal wealth by 83.2% to $4,313, and the mean annual compound return to 3.6%.
3) Missing the best 100 days reduced the terminal wealth by 99.7% to just $83 ($17 less than the initial capital invested), and reduced the mean annual compound return to −0.2%.

Wow, we wouldn’t want to miss those best days would we? Better ignore market timing and just ride through the declines.

Now here are the parts of the study you may never see because the folks publishing the data don’t want you to know how helpful market timing can be:
1) Avoiding the worst 10 days increased the terminal wealth by 206% to $78,781, and the mean annual compound return by more than one percentage point to 6.4%. (Benefit of avoiding ten worst days is $53,035 more profit vs. risk that missing ten best days might reduce results by $16,738.)
2) Avoiding the worst 20 days increased the wealth by 531.5% to $162,588, and the mean annual compound return to 7.2%. (Benefit of avoiding 20 worst days is $136,842 more profit vs. risk that missing 20 best days might reduce results by $21,433.)
3) Avoiding the worst 100 days increased the wealth by a staggering 43,396.8% to $11,198,734, (Yes, that’s $11 million!) and more than doubled the mean annual compound return to 11.5%. (Benefit of avoiding 100 worst days is $11,172,988 more profit vs. risk that missing 20 best days might reduce results by $25,633.)

Guess what – I like those odds.  But there is absolutely no evidence that market timing will cause us to miss any of those best days. That is an entirely unsupported conjecture. It is very possible to capture many of the good days and avoid many of the bad days with market timing that is less than perfect. Think about this possibility the next time you encounter one of these unfairly biased studies that attempts to show the risks of market timing. Here is some basic advice about market timing that will definitely help. You don’t need to be an expert to be a successful market timer.
1) Keep it simple. Simple market timing strategies work as well or even better than complex strategies, mainly because they have fewer assumptions. By keeping it simple, one doesn’t need to know the ins and outs of Fibonacci retracement levels, Parabolic Stop and Reverse calculations or how to count the Elliott waves.
2) Believe in the importance of trends and the assumption that whatever the current trend direction might be, it is likely to continue. If your market timing efforts are based on simply defining and then staying on the right side of the current trend then you won’t get caught up in trying to forecast tops and bottoms.
3) Know your critical time period for defining trends. If you are concerned about results over a period of years you don’t need to worry about tomorrow or the day after or worry about what happens over the next ten minutes. Give some careful thought to the time period that might have the most impact on your investments, and then learn how to define that trend. What happens over a period of months is
significant even to those long term investors that might be concerned about trends of years or more.
4) Concentrate on your exit timing. Investors in general tend to spend too much of their effort on figuring out what stocks to buy and when to buy them. They leave their exits to chance or just sell when they need to raise cash. They forget that it is the exit and not the entry that determines the outcome of an investment. Let me repeat that statement: “It is the exit and not the entry that determines the outcome
of an investment.” Please don’t forget that! Remember that Black Swan study we referenced?   If we want those big profits we have to know when to sell to avoid those big declines.
5) Don’t expect perfection. Even the world’s most successful investors make mistakes but these successful investors are quick to take their losses and move on.  Successful investors are also willing to sell a stock to reduce risk and then willing to buy it back even higher if the trend resumes. Don’t expect or attempt to buy at bottoms and sell at tops. Take it easy and just do your best to capture the easy parts of the obvious trends.
6) Do some homework. If you are looking for some suggested reading I would recommend Gerald Loeb’s classic book, The Battle for Investment Survival and Dr. Van Tharp’s more recent book, Trade Your Way to Financial Freedom. Of course, when it comes to exits I have to put in my plug for www.SmartStops.net.  It really is the best exit service bar none.
7) Always limit your risk and know how to calculate exactly how many shares to buy for each investment you make. A detailed webinar on this topic can be found on this blog in right hand column.   Controlling risk is a simple two-step process that this webinar will explain.

Believe it or not, you are now well on your way to being a successful investor and market timer. Good luck and remember to keep it simple!

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