WHAT IS OCCAM’S RAZOR?
Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.

You can't time the marketsThe appeal of market timing is obvious. Who wouldn’t want to get in and out of the market at the best time every time? We’ve talked a lot about market timing in the past – timing risk premiums, trying to time the markets on a daily basis, and the importance of staying disciplined even when it seems obvious the markets are going to go down.

This time around, I want to back up and look at market timing more generally and from a longer time frame.

The idea behind market timing is pretty simple. You want to avoid the bad times (however you define that) and get the good stuff. If you could do this, you’d be pretty well set for life (and so would a couple generations of your descendants).

To put some numbers around this, let’s look at a simple strategy of alternating between the S&P 500 Index and One-Month US Treasury Bills, and assume that you can time the markets perfectly on a monthly basis from January 1926 to July 2016.

Annualized Return Standard Deviation Growth of $1
S&P 500 Index 10.05% 18.81% $5,799.53
One-Month US Treasury Bills 3.40% 0.88% $20.54
Perfect Timing Strategy 34.17% 12.06% $356,409,474,170.78

Data courtesy of Dimensional Fund Advisors. Indices are not available for direct investment.

(If you’re this rich, you can probably fund the research to extend your life, so a ninety-year investment period isn’t completely out of the question.)

$355 billion is an absolutely insane amount of wealth (and this is for every single dollar you invested in 1926) – it’s more than the richest five people in the world combined, with a couple extra billion as petty cash.

Now let’s say we weren’t so confident in our timing and we just wanted to get out when we were really sure that the market was going down.

Annualized Return Standard Deviation Growth of $1
S&P 500 Index 10.05% 18.81% $5,799.53
Miss Worst Month 10.48% 18.53% $8,255.36
Miss Worst 10 Months 13.01% 17.26% $64,142.93
Miss Worst 5% of Months (55 Months) 19.13% 15.31% $7,569,369.65
Miss Worst 10% of Months (109 Months) 23.84% 14.13% $254,070,521.04

Data courtesy of Dimensional Fund Advisors. Data from 1/1926 – 7/2016. Indices are not available for direct investment.

As you can see, the benefits of being able to time the markets scales pretty quickly. But, even missing the worst month (September 1931 with a -29.73% return) means that you did 42% better than a boring buy and hold S&P 500 strategy.

But there are serious downsides to getting this wrong. Let’s flip that last example around. What if you miss the best months?

Annualized Return Standard Deviation Growth of $1
S&P 500 Index 10.05% 18.81% $5,799.53
Miss Best Month 9.62% 18.29% $4,072.12
Miss Best 10 Months 7.56% 16.82% $2,937.10
Miss Best 5% of Months (55 Months) 2.71% 15.40% $11.20
Miss Best 10% of Months (109 Months) -1.27% 14.42% $0.31

Data courtesy of Dimensional Fund Advisors. Data from 1/1926 – 7/2016. Indices are not available for direct investment.

(I won’t bother running through the perfectly bad timing strategy – if you’re getting it wrong every time, I’m guessing you would stop pretty quickly.)

There are a couple things to notice here. First, if you missed the single best month (April 1933 with a 42.56% return), you would have done 30% worse at the end of the period.

The second thing worth noting is just how quickly the costs and benefits of market timing occur. It’s almost never a nice gradual slope up or down. It tends to rebound and drop incredibly quickly, so you don’t get much warning when the market is about to do something important.

But if you’re committed to the idea of market timing, the downside simply means you shouldn’t screw up. If you time the markets poorly, you will get bad results. Let’s look at the likelihood of timing the markets well.

How Do Markets Work?

Prices aren’t just random blips – they actually mean something, and respond to what traders are doing. When people hear us say that prices are basically right, many of them seem to envision everything – financial news, stock values, forecasts, etc. – going into a big pot, and then prices springing forth fully formed like Athena from Zeus’s forehead. Not quite. Prices are constantly being negotiated in the market.

If someone sees a price they think is too low, they will buy the stock until either they run out of money or they have driven the price up to where they think it should be. If someone thinks a price is too high, they’ll sell or short the stock and drive the price down. That’s how the market works (at a stylized level).

Two important points to remember:

  1. This is happening constantly and quickly. In data centers focused on high frequency traders, it’s standard practice that all of the cables connecting to individual servers be the same length so no one gets that split millisecond advantage. Making sure you act on something the same day you heard about it on CNBC doesn’t really mean much.
  2. Every share needs to be owned.

The implications of the first point are pretty straightforward – by the time you hear about something, let alone can act on it, the new information is already incorporated into prices. The second point is the more important one. Let’s unpack it.

For every seller, there needs to be a buyer – someone else who is happy to take the opposite side of your trade. This means that they disagree with you (in the vast majority of cases). They want to buy at the price you want to sell at, or vice versa. If this wasn’t the case, they wouldn’t be trading with you. The market operates on differences of opinions.

Now, I say a lot of bad things about active managers and traders, but they aren’t dumb. They are basing their opinions of a stock’s worth on what has happened, what they think will happen, and their assessment of what everyone else expects to happen.

This process means prices are the best available estimate of a company’s intrinsic value, based in large part on the market’s best estimate of what will happen next. Rather than talking about every price being “right” – there’s no platonic ideal of Oracle’s stock price – I think it’s better to say that every price is wrong. We just don’t know if “wrong” means too high or too low.

Since we don’t know where prices currently stand in relation to the right price, we have no way of knowing which way the market will go next, and we won’t know until we compare the next piece of information to market expectations.

If the next piece of news is better than the market expects (or increases the certainty of something good happening), the stock will go up. If the news is worse than expected (or increases the certainty of something bad happening), the stock will go down.

Unless you can predict the future (or are substantially better at extrapolating trends than pretty much anyone else), there’s no way to tell how the markets will move in the short to medium term. As you can imagine, this makes it incredibly difficult to successfully time the markets.

You Have to Be Right Twice

To successfully time the markets, you need to be able to do it at least twice – when you get out and get back in. Let’s imagine that there was some way to reliably time the market, though not perfectly. Let’s say you could predict which way the market was going (and remember, this is pretty much impossible), but you weren’t always completely certain on the timing of when the market would shift.

Let’s go back to our simple timing strategy of being in the S&P 500 Index when the market is going up, and in One-Month T-Bills when the market is going down, but with a couple tweaks:

Annualized Return Standard Deviation Growth of $1 Percent of Perfect Timing Strategy Growth of $1
Perfect Timing Strategy 34.17% 12.06% $356,409,474,170.78
Get Out One Month Late 21.00% 15.87% $31,032,264.21 0.009%
Get Out One Month Early 22.24% 10.38% $78,028,955.92 0.022%
Get Back In One Month Late 20.16% 9.57% $16,485,122.19 0.005%
Get Back In One Month Early 19.89% 16.34% $13,504,012.01 0.004%

Data courtesy of Dimensional Fund Advisors. Data from 1/1926-7/2016. See appendix for strategy definitions. Indices are not available for direct investment.

First, we still did incredibly well, but look how poorly we did when compared to the ideal timing strategy. And we were only off by one month. In the best of these examples, we only captured 0.022% of the perfect timing strategy. In other words, these strategies are hypersensitive to any errors.

Even when you are almost perfect, you lose nearly all of the benefit. To hammer this home one more time, no one can actually be this good. Timing the market is pure chance, which I am not willing to bet my portfolio on.

(It’s interesting to note that getting the exit point of the strategy wrong wasn’t quite as bad as getting the entry point wrong. This is a great example of how quickly markets rebound from downturns.)

So What Should You Be Doing?

Timing the markets is not worth the risk, headache, or money. The potential rewards are certainly enticing, but they are impossible to get consistently.

Without being able to successfully predict what the market will be doing next, beyond the long-term risk premiums that we know and love, there is no way to actually time the market. All you’re doing is racking up trading costs, a really nasty tax bill, and adding massive amounts of noise to your portfolio.

So stick to the plan: building a portfolio around your risk tolerance so you can remain focused, disciplined, and capture the market returns you’re entitled to.

While the possibility of $360 billion sounds nice, it’s an illusory goal. All market timing does in the real world is mess up your portfolio and make it much harder for you to reach your financial objectives, which is the whole point of investing.

For more on how to build a portfolio that will help you reach your goals, take a look at our ebook 


 

 

 

Appendix

Perfect timing strategy means that in months when the return of the S&P 500 Index is positive the strategy will invest in the S&P 500 index. Otherwise, it will invest in One-Month Treasury Bills.

Get Out One Month Late means that the strategy will shift to One-Month Treasury Bills one month after the S&P 500 has a negative month, but will shift back to the S&P 500 Index for the first positive month. This means that for single month downturns of the S&P 500 Index, the strategy will remain fully invested.

Get Out One Month Early means that the strategy will shift to One-Month Treasury Bills one month before the S&P 500 Index has a negative month, but will shift back to the S&P 500 Index for the first positive month.

Get Back In One Month Late means that the strategy will shift to One-Month Treasury Bills when the S&P 500 has a negative month, and will shift back for to the S&P 500 Index for the second positive month.

Get Back In One Month Early means that the strategy will shift to One-Month Treasury Bills when the S&P 500 has a negative month, and will shift back for to the S&P 500 Index one month before the S&P 500 Index has a positive month. This means that for single month downturns of the S&P 500 Index, the strategy will remain fully invested.

 

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