After listening to Paul Merriman’s Sound Investing podcast, I found out that Paul Merriman does both indexing and market timing. He said of the $1.5 billion his company manages for clients, about 15% are invested in market timing strategies.
That’s quite peculiar. Usually people who follow indexing believe in market efficiency, which says it’s unlikely to beat the market through active management. Active management includes both security selection and market timing. I’m sure Mr. Merriman has read all the arguments against market timing. Why is he still doing it?
Instead of dismissing the practice as simply foolish or smoke and mirrors to woo clients, I decided to give Mr. Merriman the benefit of the doubt. After all he appears to be knowledgeable and experienced. I trust he has made an informed decision that indexing and market timing both have their place. Maybe he’s onto some nuances that I didn’t pay attention to before.
In the next few weeks, I will explore possible reasoning for market timing, similarly to how I did the mortgage refinance mini-series. I promise to keep an open mind. Don’t worry: I haven’t gone to the dark side. I will play the devil’s advocate and see if the arguments for market timing make sense.
I start with market timing for enhancing returns versus market timing for managing risks.
Paul Merriman says he uses mechanical, trend-following market timing strategies for managing downside risks. The goal isn’t necessarily to beat the market. When his models see the market has turned south, he would take the clients out of the market. If the market continues to go down, the clients avoid a loss. If the market goes up instead, the false alarm costs the clients forgone gains.
Academic studies showed this kind of market timing did not beat a buy-and-hold strategy. In trying to avoid a loss, the market timing moves also lost out some gains. Over the long term, the opportunity costs outweighed the avoided losses.
But what if the objective isn’t to beat the market? Suppose investors put 70% of the portfolio in stocks and get out of the market at the first sign of trouble. Doing so would underperform investing 70% in stocks at all times. What if when these same investors look at the historical worst losses, their risk tolerance only allows them to invest 50% in stocks if they must hold through thick and thin?
Using a conservative portfolio also has costs. Preparing for the worst case all the time means forgoing gains during "normal" times. A portfolio 50% invested in stocks will likely underperform a portfolio 70% invested in stocks, assuming stocks have better returns than bonds over the long term. So will a portfolio 70% invested in stocks most of the time but 30% invested at some times, assuming market timing underperforms buy-and-hold.
However, investing 70% in stocks at all times is not an option because of the investor’s risk tolerance. The question comes down to: which is a better way to manage the risks of a bear market, buy-and-hold 50% in stocks or time the market with 70% in stocks?
The answer isn’t that clear to me. Successful market timing does not have to beat the market. It only has to beat the buy-and-hold alternative based on the investor’s risk tolerance. If the investor’s risk tolerance is low but the investor can warm up to investing more in stocks when market timing means that he or she will not endure a 50% drop in stocks, is market timing necessarily worse than using a conservative portfolio?
This is a valid argument. It makes the arguments that market timing doesn’t beat the market moot because being fully invested in the market isn’t an option due to the investor’s risk tolerance.
If anyone knows academic studies that address this question, as opposed to just market timing underperforming the market, please let me know.
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Jack Costello says
I think Mr. Merriman and others who do this need to do something to justify the fees they charge. i wish they would earn their fees by utilizing proper tax management. The timing approach increases the investors tax bill when utilized in taxable accounts.
Ross Comer says
I’ve asked Merriman about this and the response was “Some of our clients insist on it.” Rather than turn away those clients, they take the money and try to do something reasonable with it. Hopefully they are educating those clients and showing the sort of analysis that can show the merits and issues of both approaches rather than just taking the money. Merriman still believes buy-and-hold is the way to go.
I don’t know about that argument. I think their are more practical ways with less uncertainty for those with low tolerance for stock market declines. Can they really plan (plan being the key word) on spending more doing this versus using a more conservative buy-and-hold? They may end up being able to, but they can’t really plan for it to work, too much uncertainty with timing. The bottom line is that they are paying more to likely underperform long-term so they can feel better in the short-term. This sounds like a doctor okaying 15% of his patients to smoke; it won’t improver their health but they won’t have to endure the stress of quitting.
paul merriman says
I appreciate the open minded discussion of timing. I have concluded most people are better using buy and hold because some investors will actually do it. Although most say they believe in buy and hold, few practice a true buy and hold approach. Most act like timers while saying timing doesn’t work. I also believe even fewer people will be able to maintain a timing strategy. There are too many emotional challenges for most investors to maintain a purely mechanical timing system.
I believe both buy and hold and timing are legitimate. My own account is 50% buy and hold and 50% timing. The buy and hold is 50% equities and 50% fixed income per my article entitled “The Ultimate Buh and Hold Strategy”. The timing portion is 70% equities and 30% fixed income. The fixed income positions with timing are very different from the buy and hold fixed income positions. The standard deviations of the two strategies are very similar, with the buy and hold slightly higher. The drawdowns with timing are smaller than the buy and hold.
Emotionally I really like the combination. When the market is in free fall the fixed income in the buy and hold position along with the timing give me a sense of peace of mind. When the bottom is finally reached and it quickly recovers, I feel pleased that I have some equities fully participating in the advance.
Of course the timing is going to be most efficient in the tax deferred portion of my portfolio.
Timing vs. buy and hold is a fascinating topic. It is ripe with misinformation from people with a bias without much information or simply trying to make a sale. I have had the good fortune of working for over ten years with the best timer I have ever met. I hope Dennis Tilley will write a book in the coming years. His view of timing is realistic and based on eliminating the hype of timing.
By the way, the return of timing and buy and hold (with our recommended asset allocation) over the last 16 years was virtually the same. The main difference is with buy and hold you accept one big mistake and with timing many small mistakes. Neither seems to be very easy for investors. It is easy for me because it is all done mechanically at the same time we do it for all our clients.
Van Beek - Stock Trend Investing says
Thanks for taking up this topic. Your question if market timing is a better way to manage risk in relation to the risk tolerance of the investor, is an interesting one. I will think it over, how this would apply to myself.
I am an enthusiastic believer in market timing…, now I must clarify this.. in long-term market timing (or you can call it long-term trend following). My intention is to buy index funds rather shortly after the beginning of a bull market and to sell these index funds again shortly after the beginning of a bear market. I measure “shortly” here in terms of months, not days or weeks. The long-term trend in the market changes direction on average only once in the two or three years. This are the trends that I want to capitalize on. I don’t know anything about timing the market in terms of hours, days or weeks, and I am not sure if short-term market timing is possible at all.
When discussing market timing, please keep the difference between long-term and short-term market timing in mind.
paul merriman says
In response to the question of short vs. long term systems I offer the following comments: Short term systems tend not to work due to the costs of trading (spreads and commissions) and multiple whipsaws. Plus the discipline becomes tough to maintain. Also, mutual fund companies don’t allow short term trading. The exception is Rydex and others which we rarely use. (a topic for another time)
The advantage of a long term system (i.e. 200 day moving average) is fewer trades than a shorter system (i.e. 100 day moving average). The disadvantage is the long term system is it gets you in and out long after the market turns. You will still have to suffer whip saws. After the market has made a big move up to get you in, it can turn right around and head down.
There is no real meaningful advantage to 200 days, compared to 100, 130 or any other reasonable system. The market pattern will always dictate which one will work best and there is no way to predict what kind of a market we will have. I know there are people who claim to know the future but not one I would want to use managing my money.
I think the most important thing to do is build a very diversified portfolio of funds. In some of the work we do we use as many as 100 to 150 funds when we are fully invested. Of course you can use margin and timing but the downside standard deviation becomes similar to a buy and hold portfolio. (another topic for another day)
I hope this information is of interest to some of you who are considering timing. I have been doing real time timing for almost 30 years and I know very few people who have used it successfully. Most timers simply can’t conclude that a simple trend following is best. They believe they will find financial nirvana is some system that combines a bunch of different variables. They are easy to find but rarely work in the future—-only in the past. From my viewpoint it’s just like the active managers who think they can out pick the stock market rather than just use index funds.
By the way, people who think timers are just coming up with ways to strip investors of their money, like the rest of Wall Street, don’t understand the challenges of being a timer. If I didn’t have timing as a part of how I help investors, our firm would probably be managing 3 times as much money as we do. A lot of people will not do business with a firm that does both timing and buy and hold. I do it because I want people to do the best they can regardless of how they want to be defensive. As some of you know I have been trying to help do it yourselfers since 1983. It’s mostly a thankless task but when it works it’s the one of the best feelings I know.