Testing Time in the Markets and Testing Market Timing

The falls in Global markets overnight and this morning emphasise the fact that equity markets do have periods of volatility. Positive periods are followed by negative periods, which are then followed by positive periods. Because of this, it is common when markets are falling to ask whether it is possible to time investment decisions to sell at the peaks and buy back at the troughs.

One way to do this might be to analyse forward-looking information such as economic and corporate data and make predictions about the direction of the markets. But it is hard to make predictions, especially about the future.

Another approach might be to look back at data from previous cycles and identify patterns that could be repeated going forward. Researchers at Dimensional Fund Advisors did exactly this, running almost 800 tests on data from 15 world equity markets to identify signals that might point to a change of market cycle and simulating the trading activity that might improve investment returns.

Most of the 800 tests failed and resulted in worse performance than would have been achieved by just going with the flow of the market. But some of the tests worked and produced positive performance results.

You might think this is good news for investors—that they can replicate the trading patterns suggested by the positive tests. Unfortunately, the number of positive results was no greater than one might expect with such a large number of tests.

As the researchers explain, the odds of one-person coin flipping 10 heads in a row are small. But if you asked 100 people to try, you would expect around five of them to be successful. The same proportion of the 800 market tests were positive and the research was unable to determine if any of them were more than just a sequence of lucky coin tosses.

The conclusion of the research is that, on average, investors are better off sticking to their long-term investment goals and riding out short-term market volatility, rather than trying to time their trading to coincide with the peaks and troughs of the market. This is also the approach we advocate at volatile times such as these.

The main defensive assets within our portfolios are short term, high quality bonds, these bonds are less volatile than long term bonds and their prices will be less effected by any rise in interest rates. High quality bonds tend to be where money flows to at times of equity market trauma and this has indeed been reflected today.

It is easy to become concerned about the present and life as an investor will involve many of these days making life less comfortable unless you view them in context so remember:

  • The value of your portfolio simply tells you how much money you would have if you liquidated everything immediately which you do not intend to do. Losses are only made if you sell assets but if you don’t do this they remain in your portfolio to generate future returns.
  • Your portfolio has a well thought out structure and is designed to provide you with the best chance of a long term favourable return.
  • Some assets will be doing well at times and others not so well and nobody can predict which assets will be doing what at any given time.
  • Your adviser cannot control what markets do and neither can fund managers.

In a nutshell, try not to worry about the short-term impact on your portfolio and instead, focus on your longer term financial plan.

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