The evidence against market timing

marketimingInvestors are exposed to a never-ending stream of newsprint articles, media talking heads, and internet chat  filled with prognostications and auguries that now is the time to buy or sell a specific stock; or now is time to jump in or jump out of stocks, bonds, or gold.

Academic studies of US mutual fund performance show that professional investors have extreme difficulty outpacing market benchmarks, and studies show  that, in the aggregate, individuals lag markets when they trade stocks or mutual funds.

Individual investors performance managing individual stocks

Academic studies by Brad Barber and Terrance Odean  (see notes below) find that individual investors experience reduced returns with their stock trading accounts, with increased active trading a key reason in lowering returns.

Examining 66,465 US household trading accounts over the 1991 – 1996 period, Barber and Odean find that the average household account earned an annual return of 16.4% over the period, compared to the 17.9% market return. Those households which traded most earned an annual return of 11.4%.

Barber and Odean also find that men are more active traders than women and earn 1.4% lower risk-adjusted returns. Single men trade more frequently than single women and earn 2.3% lower risk-adjusted returns than those earned by single women.

Out of sample studies examine the returns of Taiwanese investors. Using a complete trading history of all Taiwanese investors,  Barber, Odean et all (2007) found that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8%. They trace the shortfall to individual investor’s aggressive trading orders.

  Barber, Odean et all (2007) also examined day-trading in the Taiwanese market from 1992 – 2006 and found a return spread of 70 basis points per day between the top performing and bottom performing day traders. Less than 1% of the total population of day traders is able to predictably and reliably earn positive abnormal returns net of fees.

Individual investors performance managing mutual funds
averagereturns

Source: John Bogle, The Little Book of Common Sense Investing, p. 51.

John Bogle in his Little Book of Common Sense Investing examines the performance of mutual fund investors.

Over the 1980 – 2006 period the US market return an annualized return of 12.3%.  Over this period, the average equity fund produced an annualized 10.0% return. Individual investors earned  an annualized 7.3% return.

Chasing returns

callanchart-e1401847222303The Callan periodic table of investment returns is the best visual information showing the importance of diversification, reversion-to-the-mean, and the impossibility of forecasting asset-class returns.

John Bogle argues that investors greatly diminish their investment results by chasing historical returns. In his Little  Book of Common Sense Investing (pp.93 -97) he examines how the top ten performing funds over the three-year 1996 – 1999 period performed over the next three-years, over the complete six-year cycle, and how the investors in the funds performed.

The ten top performing funds, invested in high growth, technology and internet stocks,  provided an average cumulative return of + 279%  during the last years of the dot.com era. In the ensuing three-year bear market these funds produced  an average cumulative loss of -70%. Over the full six-year period the funds managed a cumulative return of +13%.

The funds’ investors earned a -56% cumulative return over the six-year period. This means that most investors invested in the funds after the funds’ had recorded their superior performance.

Investor return vs. fund return

Top 10 performing funds 1996 – 1999 1999 -2002 1996 – 2002 Investor return
Cumulative return 279.00% -70.00% 13.00% -57.00%

Bogle also examines investor performance in Vanguard’s Growth and Value Index funds. The bull market in growth stocks during the last decade of the twentieth century resulted in the Growth Index gaining a cumulative return of +364% over the 1993 -2000 period, compared to the +229% cumulative return of the Value index.

Over this period investors poured 11 billion dollars into the Growth Index fund, compared to investing 3 billion dollars in the Value Index fund. Growth index returns plummeted during the 2000 -2002 bear market, as did investor dollars. Over the 2001 – 2006 period the Growth Index fund experienced a net investor withdrawal of 850 million dollars, compared to a  net inflow of 2 billion dollars in the Value Index.

The table below shows the time-weighted annualized annual compound return of both indexes as well as the dollar-weighted return that investors experienced.

1993 -2006 Time weighted Dollar weighted
Growth Index 9.10% 0.90%
Value Index 11.70% 7.60%
What if we could perfectly time the market?

Mark W. Riepe, from Charles Schwab, tests perfect market timing against four other investment strategies in his article, Does Market Timing Work?

The study tracks the performance of five hypothetical long-term investors following one of the five following  investment strategies.

  • Perfect timing: investing at the market low each year;
  • Invest immediately: invest at the beginning of each year;
  • Dollar cost average: invest in 12 monthly installments (also mirrors payroll installment investments in a 401-k type retirement plan);
  • Bad timing: invest at the market high each year;
  • Stay in cash investments: stay invested in treasury bills.

Each investor received $2,000 at the beginning of every year for the 20 years ending in 2012 and left the money in the market, as represented by the S&P 500 index.

The table below shows the ranking order of performance  and  accumulated wealth over the 1993 – 2012 period for each investment strategy:

Strategy Terminal wealth
Perfect timing $87,004
Invest immediately $81,650
Dollar cost averaging $79,510
Bad timing $72,487
Stay in cash investments $51,291

The totally unrealistic strategy of perfect timing will always occupy the top place in the ranking.  The measured period was also one which included a realized equity premium return over cash investments.

The study then examined 68 rolling 20-year periods dating back to 1926. In 58 of the 68 periods, the ranking order was exactly the same. In only one period did investing immediately fall to the fourth ranking  (in 1962 to 1981, a period of weak equity markets). However, during that period, fourth, third and second places were virtually tied.

The study concludes that “the best strategy for most of us mere mortal investors is not to try to market-time at all. Instead, make a plan and invest as soon as possible.”

Notes

Next post in the investing basics series:  Simplicity

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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