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.”

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.