“Time in the market" or "Timing the market"?
Stock markets are clearly cyclical, and any investors that are fortunate enough to predict the end or beginning of a cycle would clearly make a fortune. Buying when prices are lowest and selling when prices are highest sounds simple in principle. So why can’t an investor just sell when the P/E of the market is above its historical average and buy when this reverses? Or use economic indicators like GDP growth, unemployment data and PMIs to gauge where the market is heading.
The problem with this is that the market is notoriously difficult to predict and only a fortune teller could say, “The market’s going to peak on Thursday afternoon” with full certainty. Having said that, simply purchasing a fund that tracks a market weighted index might not be the best answer either; although doing so gives you exposure to the aggregate investment manager in that particular index, it ignores all the other asset classes. It’s a fundamental belief of mine that a well-constructed portfolio should not only outperform on a risk adjusted bases, but also protect capital in times of market dislocation. The reality is that timing is integral to all aspects of investment decision making. Allocating capital across sectors, regions and factors is a key facet of portfolio management and ultimately the largest driver of under- or outperformance.
Most managers follow Modern Portfolio Theory which was essentially introduced to guide the selection and construction of investment portfolios. Markowitz (1952) assumed that investors act rationally and therefore want to maximise the discounted value of future returns.
In managing a portfolio, managers who prescribe to diversification through different asset classes and geographic exposures will usually implement one of three types of asset allocation.
Strategic asset allocation
Strategic asset allocation is a long term strategy and does not require making short term predictions in the market. Typically an asset allocation will be selected with the investor’s risk and return objectives in mind as well as expected return over the horizon period.
Tactical asset allocation
Tactical asset allocation will have a divergence from the strategic allocation weightings, based on short-term market forecasts and views. These predictions are usually based on economic fundamentals or technical variables. An example of these might be earnings or interest-rate forecasts as well as more esoteric economic indicators.
Dynamic asset allocation
Dynamic asset allocation will usually be completely or semi-unconstrained. Managers implementing this type of allocation do not believe in having a fixed strategic asset allocation. These managers believe they can consistently forecast movements in the market and thus beat the market by rebalancing asset weights. This strategy relies on the validity of the predictive model and thus can be very profitable when successful. It’s fairly common for these types of investors to be very profitable for 1 or 2 market cycles, but often the models lose effectiveness over long periods. This could be because other managers also run the same models so the trades become over crowded, or there is simply a paradigm shift in the markets. The difference between dynamic and tactical is that there are no restrictions on asset class weights, and it doesn’t conform to the idea of maximum diversification.
At Capital International we combine short-term tactical views with a longer-term strategic asset allocation, a strategy designed to provide the best possible risk and return characteristics. While tactical decisions can be implemented to exploit perceived mispricing in certain asset classes such as sectors, geographies etc., the strategic asset allocation remains the cornerstone of the overall strategy. The BHB 1986 study which focused only on variability of return, found that asset allocation explains approximately 90% of the period-to-period variability of a portfolio. Although other researchers like Xiong and Ibbotson (2010) have questioned this, ultimately it will depend on the total equity percentage of the portfolio and how high the conviction is. Clearly stock selection becomes more important in portfolios with higher equity positioning and a lower number of stocks.
Although many investors advocate the idea of “time in the market” rather than “timing the market”, is this really the best way of investing?
Whilst spending a long period of time in a particular risk asset should give a greater return than a risk free asset, sticking to a static asset allocation might not serve an investor over the long run either. Investors can often end up building positions in secular trends. On balance, my views are that time invested in the market remains more important than timing the market even if both are important.
Xiong, J., Ibbotson, R., Idzorek, T. and Chen, P. (2010). The Equal Importance of Asset Allocation and Active Management. Financial Analysts Journal, 66(2), pp.22-30.
Ferri, R. A. (2010). All About Asset Allocation: The Easy Way to Get Started. New York: McGraw-Hill, Inc.
Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.