This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.
Given the length of the current bull market, the recent Trump rally and the Dow Jones industrial average’s passing of 19,000 for the first time, many advisors are being ask the following questions:
- Should I take some chips off the table?
- Is it a good time to put my cash into the market?
- Should I change my asset allocation?
While these questions seem innocent, and maybe even prudent, they may lead to harmful investment decisions. We feel, even with the most innocent goals, making large moves in or out of the market due to undisciplined catalysts is nearly always an example of market timing.
Market Timing Should Be Easy, Right?
In American culture, we tend to feel we can win over time if we put forth enough effort. The American spirit would tell us, if we want to beat the market, it is just a matter of getting involved and focusing on the task.
How hard can it be? Intuitively, we should be able to tell if it is generally a good or bad time to invest. We dress ourselves in the morning, we pay our taxes and we commonly follow world events. Aren’t we all qualified to be successful market timers?
In a recent analysis titled, “Invest Now or Temporarily Hold Your Cash?,” Vanguard researched some aspects of market timing. It focused on the differences between investing in a lump sum, disciplined systematic investments and individual market-timing decisions.
Its research showed immediate investing (lump sum) outperformed systematic investment plans 68% of the time in the U.S. stock market from 1926-2015 on an annual basis. Likewise, the average 12-month outperformance was 2.39%. Over a 36-month interval, immediate investment outperformed approximately 92% of the time.
This research showed that lump-sum investing has historically outperformed disciplined systematic investing. The results are driven primarily by the general growth of markets over time.
Vanguard further noted it favors disciplined systematic investing over random market timing. The preference is mainly due to what it calls the increased “potential for regret” from individual market-timing decisions.
If investors know statistically they will do better if they invest in a lump sum, why do some investors try to time their way in and out of the market?
Call A Spade A Spade
Many victims of market timing simply may not know they are doing it. We would guess most nonprofessional investors couldn’t provide an eloquent description of market timing, just as we couldn’t tell you exactly how most prescription medications work.
Toward further complexity, market timing is not a binary classification. We understand each trade made happens at a particular time and, because the market is open most days, that trade could have been made at a different time. Someone, or something, made the decision of “when.” However, we believe there are different degrees of market timing.
The gradient nature of market timing can lead to complacency. A quick carnival example might help to illustrate. “Someone who ate cotton candy” could be someone who ate two bites of cotton candy or someone who ate two bags of cotton candy. There is a meaningful difference between the consequences of eating two bites versus two bags.
Since every investment strategy involves some level of market timing, many investors fail to note the major difference in degrees to which market timing takes over their strategy. Like cotton candy, we encourage investors to exercise discipline to eat just two bites and not two bags.
Moderation As Your Guide
As Marcus Tullius Cicero said: Never go to excess, but let moderation be your guide.
To help describe our strategic discipline, we have developed the following chart, which outlines how focused market timing fits in the continuum of investment management styles:
Hypothetical – for illustrative purposes only. ValMark Advisers™
The Allure Of Carnival Games
Market timing requires you to be correct at least twice, which is twice as hard as being correct once: Investors must correctly time the buy and the sell. Even if there is a 50/50 chance of being right once, there would only be a 25% chance of being right twice in a row.
However, to compound the difficulty of exercising market-timing discipline, it seems easier than it is. Whenever something seems easier than it is, you will find people willing to try it and people willing to enable others to try it. This made us think of carnival games.
We have all played carnival games at some point. The oval basketball rim, the whiffle ball that won't bank into the laundry basket and the dull darts that won't pop an underinflated balloon are a few classic games. We have all lost money over the years on these "games of chance."
Game Of Chance Requires A Chance
Over time, most of us have realized these games of chance are hardly games of chance. It is hard to call something a game of chance if you have almost no chance of winning.
After realizing the chances of winning are nearly impossible, rational people would stop playing the game. Unlike casino games with established odds, you won't see a professional league or corner location offering regular play of carnival games. No one in their right mind would play carnival games consistently over time.
What if, however, you were paid an annual fee to provide carnival games? Whether you won or lost, you would be paid above-average wages to promote the tossing of dull darts at underinflated balloons. Would you promote the chance of success, or the chance of failure?
It is important for investors to understand that those offering market-timing services typically get paid whether they are right or wrong. This doesn’t make them bad—we just note the fact that just because market-timing services exist doesn’t by itself mean they all work.
Think Of Your Family
How should we decide if we want to be market timers? When in doubt, we typically think about what we would do for our family. We all make bad decisions for ourselves that we would not let our family make. For example, we might drive slower with our family in the car, or we might worry more about the safety of a flight when our family is aboard.
Presumably, we want our families to be safe and healthy, and our overall decision-making process will be driven by increasing chances of success in reference to our families.
Assuming those reading this article have an interest in investing, we might assume those reading this article drive investment decisions in their marriage. Imagine you were going away on a space shuttle for 20 years and then returning to join your spouse in retirement.
Would you tell your spouse to try and time in and out of the market to optimize returns? Would you suggest your spouse put all of your marital investments into a market-timing strategy?
We hope the answer is "no" to both of these questions.
If you don't believe your spouse has this magical market-timing ability, and you currently try to market-time, it must be faith in yourself or one specific market timer and respective magical abilities. If so, maybe your faith was tested by the recent presidential election outcome, or the results of the “Brexit” vote, as both outcomes would have been difficult to properly time.
ETFs Can Help & Hurt Market Timers
As one of the country’s largest managers of ETF portfolios, we are incredibly pleased with the progression of the ETF industry from when we started managing ETF portfolios in 2002. Each year, we are able to honestly state the industry has never been better.
Several aspects of ETFs, including the following five bullet points, have helped to reduce the need to make market-timing decisions:
- Index investing
- Trading technology
- Tax efficiency
- Lower fees
Earlier in the transition of the investment industry from higher-priced active management to index-based investments, successful investors had to make investment changes frequently. To be successful, you had to try and consistently pick top active managers. Since we believe most active managers don’t remain successful for long periods of time, you would have to change frequently.
Likewise, with low transparency in some actively managed portfolios, investors often had to change investments due to a misalignment in goals. Further, tax inefficiency and higher fees caused investors to make market-timing decisions.
With a plethora of what we feel are quality, low-cost, index-based and efficient ETFs, investors are not forced to constantly turn over their core holdings. ETFs should help investors to reduce the chances of making poor market-timing decisions.
However, choice and liquidity in ETFs has actually helped to feed some market-timing strategies. Those trying to time the market can use ETFs effectively to carry out their investments, although, we would support not blaming the tool for the outcome of the craftsmen.
When Might You Market-Time?
There are a few situations where a little market timing might make sense. As we described above, market timing is not necessarily a binary concept. There are four scenarios that may arise.
- Working with financial planners throughout the country, we know income planning is a key part of the financial planning process. We would advocate for investors to pay close attention to the timing of liquidations for cash needs. If the opportunity does avail itself to liquidate assets after a recent period of significant market growth, we would understand liquidating assets you are expecting to use soon for cash needs.
- Secondly, we feel it may make sense to rebalance your disciplined portfolio allocation after a recent period of above-average market growth. However, the trigger for this event should be some sort of discipline that has been set up to monitor drift from a target allocation.
- Thirdly, we feel it might be necessary to exercise some market timing due to significant changes in market-based assumptions. If your strategic target allocation was based on certain assumptions, and those assumptions change unexpectedly, this might cause a need to adjust and make a judgment call on timing.
- Lastly, there are disciplined hedging strategies designed to reduce exposure to equities in periods of high volatility. We feel proven systematic risk reduction strategies can add value over time. However, it is important to remain disciplined and not try to time in and out of an established hedging strategy.
Please Don’t Regress
If you are a disciplined investor, please don’t regress to the natural tendency to market-time. If you get the temptation, we would encourage you to think about carnival games. Maybe you could only allocate the percentage of your net worth to true market timing that you would be willing to allocate to playing the oval-rimmed basketball game.
ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.