The Case Against Market Timing

March 19, 2021
Deputy Chief Investment Officer Justin Reed and Head of Investment Research Tom Martin discuss market timing. They explore its allure and pitfalls, stressing our belief that the adoption of a value-oriented, bottom-up investment approach, along with a long-term investment horizon and prudent rebalancing plan, is a far more compelling investment strategy.

There are only two types of people: those who can’t market time, and those who don’t know they can’t market time.  



Terry Smith (Fundsmith)

Heading into 2020, many investors believed that market valuations were stretched. All major asset classes generated positive results in 2019. Equities reached record highs, and the S&P 500 returned 31.5%. As of year-end 2019, the S&P 500’s 10-year annualized return stood at 13.6%, compared to its long-term average return of 10.0% (1926 to 2018). In addition to valuation concerns, investors were still digesting the news of an inverted yield curve (August 2019), the escalation of the U.S.-China trade dispute and the continuation of Brexit negotiations. It appeared to many investors that this combination of circumstances would lead to poor market performance in 2020. With this as a background, imagine if one of our Brown Brothers Harriman (BBH) colleagues could then have accurately predicted the macroeconomic and political events of 2020. Even if this was possible, it would be difficult to describe a forecast for 2020 that would be as dire as the actual events: a global pandemic leading to millions of fatalities and drastically impacting economies worldwide, the first of two impeachment proceedings for the sitting U.S. president, large-scale social movements, a U.S. presidential election that witnessed legal challenges to overturn the results and anti-trust lawsuits against several of the “FAAMG” stocks, among other events. A prediction of just a fraction of the turmoil of 2020, coupled with the known performance data from 2019, would have likely led many investors to move most liquid assets to cash as a result of this information.

Yet, as we write this article in early 2021, we can report that 2020 was a strong year for most of the major asset classes. If an investor would have tried to time the market by moving to cash ahead of 2020, he or she would be much worse off today, given respective 2020 returns of 18.4% and 7.5% for the S&P 500 and Bloomberg Barclays Aggregate. These facts exemplify the reality that even if one had perfect foresight into geopolitical and macro events, predicting subsequent market movements is extremely challenging.

Of course, investors would love to be able to time the market perfectly, investing at market bottoms and moving to cash at peaks. Unfortunately, such market timing is challenging for all investors, no matter how sophisticated. We adhere to the adage that “it is about the time in the market, not timing the market” which allows investors to best position themselves for strong long-term results. A long time horizon that benefits from the power of compounding is much more impactful, and generally more successful, than the mirage of market timing. The case against market timing is strong and supported by a large body of research conducted by BBH as well as academic studies. We believe that instead of trying to time the market by monitoring broad market, economic or political indicators, investors should utilize a bottom-up, fundamental approach with a long-term horizon to select high-quality individual securities trading at a discount to estimates of intrinsic value. Such an approach is the most predictable way to generate attractive long-term returns. In addition, investors are also well served by implementing a thoughtful, programmatic rebalancing strategy that optimizes the benefits of such actions with the potential tax consequences.

What Is Market Timing?

We define market timing as the speculative strategy of making buy or sell decisions based on predictions of short-term market price movements. Importantly, market timing decisions are based on estimating the returns of the market (or corresponding index), such as U.S. large-cap stocks, rather than a particular security.

Market timing strategies can involve several different approaches. One approach employs using nonfinancial indicators to predict market movements. For example, one may attempt to predict what may happen to U.S. equity markets if a given presidential candidate were to win an upcoming election. Such an investor may determine that the risk of an unfavorable candidate winning the election warrants staying out of the market until the election is resolved. Another approach involves the use of technical indicators, such as historical prices. In this case, an investor engaging in market timing might notice that the MSCI ACWI has generated positive returns for the past five years and thus may decide to wait for the “bubble” to burst. Yet another common approach is timing based on historical market valuations. An investor utilizing this approach may make valuation comparisons across time or different markets. For example, one might compare the S&P 500’s price-to-earnings (P/E) ratio today vs. its P/E ratio in 2009 or vs. the MSCI Emerging Markets Index’s current P/E ratio. While keeping track of each of these data points can be helpful, attempting to make entry or exit decisions based on them is likely to be detrimental to long-term returns. There are simply too many other variables that influence market returns over the short to medium term. It is also difficult for anyone to make accurate predictions on such macro issues over a long period of time.

What Is the Allure of Market Timing?

Despite the abundance of evidence suggesting that market timing is a futile exercise, its allure persists. Why? One hypothesis is that this strategy is a response to the legitimate realities of investing as well as behavioral biases. Specifically, all investors can see how beneficial it would be if one could predict market movements and adjust a portfolio in advance of those movements. If it were possible, doing so would allow one to dramatically outperform the gold standard of a buy-and-hold strategy over the long term. For example, if an investor could exit asset classes that were going to generate poor performance over the next year and rotate into asset classes that would generate strong performance over the same period, returns would be enhanced, volatility would be avoided and losses would be curtailed.

Looking at the nearby chart, the “all-knowing” investor would have moved out of REITs and into small-cap equities at the end of 2015, only to rotate into emerging market equities at the end of 2016. In theory, that investor would be able to generate returns at a level rarely attained. If we assume that for the past 15 years, at the end of each year the investor was able to rotate 100% of her portfolio out of the highest-returning asset class for that past year and rotate into the highest-returning asset class for the following year, she would have generated an annualized return of 25.1%, gross of fees and taxes, meaningfully outperforming the otherwise impressive 9.8% annualized return of U.S. large caps over the same period. Despite this return potential, we rarely hear of people that have accumulated vast sums of wealth this way. As Peter Lynch said, “I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it.”


 
Year S&P
500
Russell
2000
MSCI
EAFE
MSCI
EM
Bloomberg Barclays
US Agg Bond
Bloomberg Barclays
Municipal
Bloomberg Barclays
HY Corp
Bloomberg Barclays
US T-Bills
2006 32.1%
MSCI EM
26.3%
MSCI EAFE
18.4%
Russell
2000
15.8%
S&P 500
11.8%
Bloomberg Barclays
HY Corp
4.8%
Bloomberg
Barclays Municipal
4.8%
Bloomberg Barclays
US T-Bills
4.3%
Bloomberg Barclays
US Agg Bond
2007 26.3%
MSCI EAFE
11.2%
MSCI EAFE
5.5%
S&P 500
5.5%
S&P 500
5.0%
Bloomberg Barclays US T-Bills
3.4%
Bloomberg Barclays Municipal
1.9%
Bloomberg Barclays HY Corp
-1.6%
Russell 2000
2008 5.2%
Bloomberg Barclays
US Agg Bond
2.4%
Bloomberg Barclays
US T-Bills
-2.5%
Bloomberg Barclays Municipa
-26.2%
Bloomberg
Barclays HY Corp
-33.8%
Russell 2000
-37.0%
S&P 500
-43.4%
MSCI EAFE
-53.3%
MSCI EM
2009 78.5%
MSCI EM
58.2%
Bloomberg Barclays
HY Corp
31.8%
MSCI EAFE
27.2%
Russell 2000
26.5%
S&P 500
12.9%
Bloomberg Barclays Municipal
5.9%
Bloomberg Barclays US Agg Bond
0.3%
Bloomberg Barclays US T-Bills
2010 26.9%
Russell 2000
18.9%
MSCI EM
15.1%
S&P 500
15.1%
Bloomberg Barclays HY Corp
7.8%
MSCI EAFE
6.5%
Bloomberg Barclays US Agg Bond
2.4%
Bloomberg Barclays Municipal
0.2%
Bloomberg Barclays US T-Bills
2011 10.7%
Bloomberg Barclays
Municipal
7.8%
Bloomberg Barclays
US Agg Bond
5.0%
Bloomberg Barclays HY Corp
2.1%
S&P 500
0.1%
Bloomberg Barclays US T-Bill
-4.2%
Russell 2000
-12.1%
MSCI EAFE
-18.4%
MSCI EM
2012 18.2%
MSCI EM
17.3%
MSCI EAFE
16.3%
Russell 2000
16.0%
S&P 500
15.8%
Bloomberg Barclays HY Corp
6.8%
Bloomberg Barclays Municipal
4.2%
Bloomberg Barclays US Agg Bond
0.1%
Bloomberg Barclays US T-Bills
2013 38.8%
Russell 2000
32.4%
S&P 500
22.8%
MSCI EAFE
7.4%
Bloomberg Barclays HY Corp
0.1%
Bloomberg Barclays US T-Bills
-2.0%
Bloomberg Barclays US Agg Bond
-2.6%
MSCI EM
-2.6%
Bloomberg Barclays Municipal
2014 13.7%
S&P 500
9.1%
Bloomberg Barclays Municipal
6.0%
Bloomberg Barclays US Agg Bond
4.9%
Russell 2000
2.5%
Bloomberg Barclays HY Corp
0.1%
Bloomberg Barclays US T-Bills
-2.2%
MSCI EM
-4.9%
MSCI EAFE
2015 3.3%
Bloomberg Barclays Municipal
1.4%
S&P 500
0.5%
Bloomberg Barclays US Agg Bond
0.1%
Bloomberg Barclays US T-Bills
-0.8%
MSCI EAFE
-4.4%
Russell 2000
-4.5%
Bloomberg Barclays HY Corp
-14.9%
MSCI EM
2016 21.3%
Russell 2000
17.1%
Bloomberg Barclays HY Corp
12.0%
S&P 500
11.2%
MSCI EM
2.6%
Bloomberg Barclays US Agg Bond
1.0%
MSCI EAFE
0.4%
Bloomberg Barclays US T-Bills
0.2%
Bloomberg Barclays Municipal
2017 37.3%
MSCI EM
25.0%
MSCI EAFE
21.8%
S&P 500
14.6%
Russell 2000
7.5%
Bloomberg Barclays HY Corp
5.4%
Bloomberg Barclays Municipal
3.5%
Bloomberg Barclays US Agg Bond
0.8%
Bloomberg Barclays US T-Bills
2018 1.9%
Bloomberg Barclays US T-Bills
1.3%
Bloomberg Barclays Municipal
0.0%
Bloomberg Barclays US Agg Bond
-2.1%
Bloomberg Barclays HY Corp
-4.4%
S&P 500
-11.0%
Russell 2000
-13.8%
MSCI EAFE
-14.6%
MSCI EM
2019 31.5%
S&P 500
25.5%
Russell 2000
22.0%
MSCI EAFE
18.4%
MSCI EM
14.3%
Bloomberg Barclays HY Corp
8.7%
Bloomberg Barclays US Agg Bond
7.5%
Bloomberg Barclays Municipal
2.3%
Bloomberg Barclays US T-Bills
2020 20.0%
Russell 2000
18.4%
S&P 500
18.3%
MSCI EM
7.8%
MSCI EAFE
7.5%
Bloomberg Barclays US Agg Bond
7.1%
Bloomberg Barclays HY Corp
5.2%
Bloomberg Barclays Municipal
3.2%
Bloomberg Barclays US T-Bills
Source: Bloomberg.
Past performance does not guarantee future results.

Several behavioral finance concepts also help to explain market timing’s allure. Hindsight bias is people’s tendency to remember their own predictions of the future to have been more accurate than they were in reality. This often leads people to conclude that they can more accurately predict future events than is warranted. In his book, “Thinking, Fast and Slow,” Daniel Kahneman presents a useful example of this bias in practice. Heading into the great financial crisis in 2008, there were few investors who thought there may be an impending crisis, but now there are “far too many people who claim to have known well before it happened that the 2008 financial crisis was inevitable,” despite the fact that the “crisis was unknowable.” Such thinking may lead otherwise well-intentioned investors to be overconfident in their market timing abilities.

Another behavioral bias that helps illuminate the allure of market timing is loss aversion, which is the tendency for people to weight losses larger than gains when directly compared against each other.1 Loss aversion helps to explain why some investors, after coming to the conclusion that the market is frothy from a valuation perspective, consider holding off on investing and wait for a pullback. Investing and then watching your portfolio drop by 5% feels more painful than the corresponding happiness if the portfolio had gone up 5% over the same time period. All else being equal, this bias can lead investors to market time by inappropriately keeping their portfolios in cash even though investing the capital is typically the more prudent decision to make.

Arguments Against Market Timing

The Unpredictability of Market Cycles

We believe that market timing is a fundamentally flawed approach for several reasons. First, the timing and magnitude of relative performance differentials (between asset classes) and market cycles are inherently unpredictable. In the short term, swings in investor sentiment and the related impact on valuation multiples often drive large swings in performance, but there are no durable or repeatable strategies to predict such changes. For example, we know of no reliable way to have predicted that U.S. small-cap equity would be the best-performing asset class in 2016, followed by emerging markets equity as No. 1 in 2017. How could anyone predict that an increase in the Russell 2000’s P/E ratio would contribute almost 15% to the index’s 2016 performance, or that it would contribute 18% to the performance of the MSCI Emerging Markets Index the following year?2

Longer term, larger market cycles are often driven by macroeconomic factors (e.g., interest rates and inflation), “bubbles” or financial crises, yet history has shown that forecasters are not adept at predicting these events either. The following table shows the S&P 500’s nine worst drawdowns and the surrounding events related to the decline. Categorizing the nature of the precipitating events for these drawdowns illustrates that, by their nature, the events are relatively unpredictable occurrences. A handful of investors always seem to avoid a single market drawdown, but the evidence shows that it is nearly impossible to do this consistently over time. Thus, after accounting for all market timing trades (successful and unsuccessful), the long-term track record of those who engage in market timing seems to be almost universally poor.

Market Peak
Date

Surrounding
Event(s)

Category Peak-to-Trough
S&P 500 Return
1/11/1973 Inflation Shock, OPEC Oil Embargo Inflation (44.8)
11/28/1980 Volcker/FOMC Interest Rate Hikes Monetary Policy (20.2)
10/5/1987 Black Monday Computer-Driven Selling,
Investor Panic
(31.3)
7/17/1998 Asian Currency Crisis, LTCM, Russia Default Financial Crisis (19.2)
9/1/2000 Tech and Telecom Bubble Bubble (47.4)
10/9/2007 Housing Bubble, Global Financial Crisis Bubble, Financial Crisis (54.8)
7/7/2011 Debt Ceiling, U.S. Credit Rating Downgrade Sovereign Downgrade (18.4)
7/21/2015 China, Energy, Manufacturing Recession Country and Sector-Specific
Stress
(12.6)
3/4/2020 COVID-19 Global Pandemic Pandemic (28.4)
Source: Bloomberg and BBH Analysis.

Timing Buy and Sell Decisions

Second, even if we assume that one can predict events that will lead to market declines, he or she must also predict the correct time to buy and sell. Investors who predicted the tech bubble in the late 1990s or the housing bubble in 2005-06 still had to decide when to sell. In hindsight, the tech bubble was well underway in fourth quarter 1999 (the Nasdaq was up 48%) but continued to climb another 84% before peaking in March 2000. Investors that were smart enough to predict the bubble then had to hold on until it burst. Similarly, the housing bubble was in full swing by 2005; however, prices did not crack until early 2007, and the stock market did not peak until October 2007. The market then lost 15% but did not sell off in earnest until the Lehman Brothers bankruptcy almost a year later in September 2008. To be successful, investors need to time their trades well, but then also have the temperament to hold on while the market marches higher.

Additionally, investors who are so lucky as to have sold prior to a market peak still need to decide when to buy back into the market. There are likely many more investors that have sold at the right time than those that have sold and reinvested appropriately. While investors are busy taking a victory lap for calling the peak correctly, the market can bottom and come roaring back more quickly than expected. The 2020 market environment provides the perfect example: The S&P 500 bottomed on March 23, 2020; however, it rallied almost 18% in the next three trading days. The market continued to recover and, despite the ongoing recession, had regained its prior high by mid-August, roughly six months after its prior peak.

Taxes and Transaction Costs

Yet another reason to avoid market timing is that it causes the realization of unnecessary taxes and transaction costs. While this is more of a concern for taxable investors, even tax-exempt investors must be mindful of transaction costs, as trading in illiquid asset classes during volatile markets can lead to steady leakage from long-term returns. For taxable investors, the bar for market timing is even higher because paying taxes disrupts the process of compounding.

Impairment of Returns

An overwhelming body of empirical evidence suggests that the overall odds of succeeding with a market timing strategy are low. Morningstar’s annual “Mind the Gap” study of investor returns, for example, suggests that market timing has impaired investor returns, finding that in the 10 years ending in 2018, which includes investor behavior surrounding the global financial crisis, the average investor lost 45 basis points of annual returns to market timing.3

What Can Investors Do?

Market timing, in its various forms, is clearly not a strategy that will maximize returns over the long term. So, how can investors better position their portfolios to generate strong long-term returns? We believe that maximizing long-term returns starts with a thoughtful, consistently applied investment philosophy. Specifically, a value-oriented, bottom-up approach emphasizing deep diligence, a focus on capital preservation, a disciplined and patient style of investing and a long time horizon are foundational to achieving strong long-term results. This philosophy leads us to invest in managers who are concentrated and only invest in securities they know extremely well and where they have a differentiated perspective. As a result, our managers do not own the market (e.g., they are not “closet indexers” that closely track the index and charge active management fees), nor do they make portfolio decisions based on shorter-term broad market, economic or political indicators. Instead, their portfolio reflects the portfolio manager’s conviction level in a limited number of individual securities, based on assessments of the discount each security is trading to an estimate of intrinsic value.

Charlie Munger once said: “The first rule of compounding is never to interrupt it unnecessarily.” A central tenet of BBH’s investment approach is a long time horizon, and we believe that we will be more successful investing on behalf of our clients by letting our investments compound in value over time and sticking to our intended asset allocation plan, as opposed to timing our investments into and out of markets. As shown in the nearby chart, which measures the percent of rolling time periods that are positive or negative for the S&P 500, a longer investment horizon is associated with an increased probability of generating positive returns. Thus, investors should take some comfort that with an appropriate time horizon the wind will be at their back.


Source: Yahoo Finance.
Percentage of Positive/Negative S&P 500 Rolling Returns
December 30, 1927 –February 2, 2021
  1 Year 3 Year  5 Year 10 Years
# of Positive Period 15,957 17,598 17,487 18,407
# of Negative Period 7,175 5,034 4,643 2,479

In addition to a fundamental, bottom-up investment philosophy, we believe that a thoughtful approach to rebalancing helps to best position portfolios for long-term success. Rebalancing back to asset allocation targets, assuming that a client’s risk and return goals are unchanged, is an important exercise. It is helpful to recognize that while rebalancing involves trading, it has a different purpose than market timing. The primary objective of rebalancing is to keep a portfolio aligned with the client’s desired risk tolerance, and our preferred method is to set thresholds around asset class targets and rebalance only when those have been breached.

Thoughtfully implementing such a programmatic approach eliminates the otherwise difficult and subjective challenge of figuring out when to rebalance and removes the temptation to make rebalancing a thinly veiled attempt at market timing. Despite the fact that rebalancing often entails selling higher-returning asset classes (equities) and buying lower-returning investments (fixed income), some academic studies still find that a well-designed and consistently implemented rebalancing strategy, in addition to its risk mitigation benefits, is associated with higher returns in volatile markets. A 2008 study in the Journal of Financial Planning, for example, found that an opportunistic rebalancing strategy during the 13-year period from 1992 to 2004 was associated with higher pretax returns than a buy-and-hold strategy.4

In conclusion, we believe that the adoption of a value-oriented, bottom-up investment approach, along with a long-term investment horizon and a prudent rebalancing plan, is a far more compelling investment strategy than market timing.

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1 Daniel Kahneman and Amos Tversky.
2 Bloomberg. Adjusted P/E on positive earnings went from 19.1x on 12/31/2015 to 21.9x on 12/31/2016.
3 Morningstar. “Mind the Gap 2019.”
4 Daryanani, Gobind. “Opportunistic Rebalancing: A New Paradigm for Wealth Managers.” Journal of Financial Planning. January 2008.

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