'Market timing' falls short as investment strategy

WHENEVER THE PUBLIC securities market experiences extraordinary price volatility, most investors begin to question their investing discipline. It can be unsettling to see markets fluctuate wildly.

These also can be scary times for not-for-profit organizations that also bear the responsibility of trying to invest longer-term cash wisely. Market volatility provides opportunities to review both individual holdings and investment philosophies.

While most non-professional investors are fearful of significant price swings, most professional investors embrace volatility as an investing opportunity. Both views, one half-empty, the other half-full, suggest that a change in asset allocation may be warranted because of the increase in volatility. Such an asset allocation procedure is known as “market timing.”

The key distinction between the half-full and half-empty perspectives is that market timing for non-professional investors generally is not an asset allocation strategy, but rather a maneuver in response to market volatility.

However, market timing for professional investors can be considered a tactical maneuver when it is employed under the guise of achieving certain strategic goals, which might include a strategy known as “GARP,” or growth at a reasonable price.

For example, while fundamental analysis may suggest a particular equity investment, further study may show that the current price of the stock is too high to be considered reasonable. The portfolio manager then would watch for a decline in the price of the stock to the appropriate target. Then, a final review can confirm the desired inclusion of the stock in the portfolio as part of the GARP strategy. GARP managers generally look for opportunities in stocks that are temporarily out of favor. But that’s their strategy, their discipline. GARP managers are not, by definition, market timers.

Is market timing ever a strategy, then? For a few professional investors, absolutely. But this article is about non-strategic market timing. In the absence of discipline, market timing is normally a response to fear. The volatility seen in today’s securities markets has caused many investors to question their discipline.

Is there risk to “being defensive” in a market wrought with volatility? After all, not-for-profit investors cannot afford to sustain significant losses to hard-earned development dollars. Indeed, they have a fiduciary obligation to the assets under their care. There is a difference, however, in the responsibilities of a not-for-profit’s management and its governance. Investment strategy is a governance issue.

A few very successful investors have weighed in on the value of market timing. John Bogel, founder of the Vanguard Group and the father of the index fund, wrote of market timing that, “After nearly 50 years in the business, I do not know of anybody who has done it successfully and consistently. I do not even know anybody who knows anybody who has done it successfully and consistently.” Peter Lynch, who ran Fidelity’s Magellan Fund from 1977 to 1990, once said, “I don’t remember anybody predicting the market right more than once, and they predict a lot.” Both Bogel and Lynch believed that market timing offered little value.

Let’s look at the numbers. During the 15 years, from Nov. 30, 1992, to Nov. 30, 2007, the Standard & Poor’s 500 Index had an average annualized return of 10.63 percent, including reinvestment of dividends. There have been several volatile periods in the equity market during that period – quite a few opportunites for fear to overtake one’s discipline.

What if an investor decided to “time the market” and was unfortunate enough to miss the top 10 best-performing days of the S&P 500 Index in that period? In that 15-year period of more than 3,700 trading days, that investor’s return would be only 7.20 percent. Missing the top 20 days would reduce the average annual return to only 4.57 percent.

Does staying out longer have a more positive effect? Not if you missed the top 40 performing days of the S&P 500, in which case an investor’s return for those 15 years would have been only 0.32 percent, including dividends.

Forecasting the effect that negative events will have on securities markets is very difficult. Calculating the magnitude of the resulting market movement is even more difficult. Predicting the timing of negative events is virtually impossible. To be a successful market timer, one must accurately foresee each of these events. But market timing is not just about when to sell – it’s also about when to buy again. Some say that only one investor buys at the very bottom, and only one investor sells at the very top. And it’s never the same investor.

It’s about time in the market, not timing the market. As long-term investors, not-for-profit organizations can tolerate a certain level of volatility in the investment markets. However, the recent declines seen in the markets should serve as a reminder that volatility exists even as markets move up.

Erratic market moves offer a sign that it’s time to review policies, procedures and practices.

At the very least, such discipline demands that the investment policy statement has budgeted suitable risk relative to the organization’s financial health, and that the spending policy accurately reflects the sources and uses of the endowed funds. Only then can fiduciaries set strategies intended to optimize returns that reflect the mission of the organization, not the current market environment.

William M. Courson is the president of the Lancaster Pollard Investment Advisory Group, which works exclusively with not-for-profits to manage their total financial risk and ensure their missions last in perpetuity. Reprinted with permission from The Capital Issue at www.lancasterpollard.com