Time in the market versus timing the market

January 2008

At the moment we are hearing and reading a great many commentaries that are pretty bearish about 2008. At times like this it can be very unnerving to be an investor. But it is also a helpful time to step back and remember the investment principles and disciplines that we stand for at Paradigm Norton.

Perhaps the simplest, but most important, is that we do not believe we can time markets, and if we sought to do so, we have just as much chance (if not more!) of losing money than making money.

We have heard it said that there are only two kinds of economist: those who don’t know what is going to happen, and those that don’t know they don’t know what is going to happen! A great many people with considerably more expertise and knowledge than Paradigm have lost fortunes trying to time markets. Of course, everyone hears of George Soros making billions timing currency markets, but perhaps less well known is the fact that John Maynard Keynes (by most standards, a giant of economics) made and then lost two fortunes timing markets.

The difficulty is that we don’t know what we don’t know. Nobody knows for sure what is going to happen in 2008, and how markets will respond. In terms of the doom and gloom in many commentaries, the investment purists would argue that markets these days are so efficient (i.e. all investors and investment managers have access to the same information at the same time) that much of the bad news we are aware of has already been priced into the market. Indeed, this may explain the volatility and the couple of market corrections that took place during the autumn. Consequently, the outlook for 2008 may not be so bad after all, as the bad news we are all hearing is already factored into current prices. Therefore, markets will only respond to new news which by definition is unknowable.

Having said that, we are not trying to suggest that 2008 will be a positive year for markets, In all likelihood it may indeed be a bad year, and markets may indeed fall. But the reality is, we don’t know. Therefore, if we try to time markets, we will invariably get it wrong and impose transaction costs in doing so.

Often, the problem with market timing is not so much when to get out, but when to get back in. We remember the FTSE falling from 6900 in 1999 to 5500 in 2000, a fall of 20%. We also remember thinking, “surely this is the bottom, surely markets won’t fall further, they must rise soon”. Of course, none of us saw 9/11 coming, and in fact, markets kept falling, and reached 3200 in March 2003! However, the real pain is often suffered by getting out of markets and missing the recoveries, which invariably happen rapidly in short sharp bursts. It is a well known market truism that if you miss these you miss the returns of the market.

As you know, we are required to plaster over every recommendation that funds can go down as well as up. Often clients are happy to accept this in rising markets, but don’t like to hear it in falling markets. The key, however, to achieving long term financial goals is to set a strategy that reflects your attitude to risk, asset allocate your portfolio accordingly, and diversify across a range of funds and investment strategies to meet that asset allocation. Then stick to the strategy, enjoy the good times, and accept that there will be times of falling markets and falling values too. However, over the long term, if you stick to the strategy, you should achieve your long term target return on average, even though some years will be above average, some below average, and some will be negative.

“Triumph of the Optimists: 101 years of Global Investment Returns” by Dimson, Marsh and Staunton of London Business School is the definitive text on market history and demonstrates this point perfectly. The global equity risk premium (investment return in excess of the risk free rate – e.g. cash) across 16 countries between 1900 and 2000 was 5.8%. However, to earn this premium there are highs and low lows to be suffered along the way. There is no free lunch for earning what has been an extraordinary handsome but long term reward for investing in the capitalist system.

Nevertheless, if you remain concerned about market volatility and the outlook for 2008, then rather than us timing markets, it may be appropriate to re-consider with you whether the risk profile of your portfolio is appropriate. If you think you might find this helpful, please do contact us.