The evidence against market timing
Investors are exposed to a never-ending stream of newsprint articles, media talking heads, and internet chat filled with prognostications and auguries that now is the time to buy or sell a specific stock; or now is time to jump in or jump out of stocks, bonds, or gold.
Academic studies of US mutual fund performance show that professional investors have extreme difficulty outpacing market benchmarks, and studies show that, in the aggregate, individuals lag markets when they trade stocks or mutual funds.
Individual investors performance managing individual stocks
Academic studies by Brad Barber and Terrance Odean (see notes below) find that individual investors experience reduced returns with their stock trading accounts, with increased active trading a key reason in lowering returns. Examining 66,465 US household trading accounts over the 1991 – 1996 period, Barber and Odean find that the average household account earned an annual return of 16.4% over the period, compared to the 17.9% market return. Those households which traded most earned an annual return of 11.4%.
Barber and Odean also find that men are more active traders than women and earn 1.4% lower risk-adjusted returns. Single men trade more frequently than single women and earn 2.3% lower risk-adjusted returns than those earned by single women. Out of sample studies examine the returns of Taiwanese investors. Using a complete trading history of all Taiwanese investors, Barber, Odean et all (2007) found that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8%. They trace the shortfall to individual investor’s aggressive trading orders. Barber, Odean et all (2007) also examined day-trading in the Taiwanese market from 1992 – 2006 and found a return spread of 70 basis points per day between the top performing and bottom performing day traders. Less than 1% of the total population of day traders is able to predictably and reliably earn positive abnormal returns net of fees
Individual investors performance managing mutual funds
John Bogle in his Little Book of Common Sense Investing examines the performance of mutual fund investors.
Over the 1980 – 2006 period the US market return an annualized return of 12.3%. Over this period, the average equity fund produced an annualized 10.0% return. Individual investors earned an annualized 7.3% return.
The Callan periodic table of investment returns is the best visual information showing the importance of diversification, reversion-to-the-mean, and the impossibility of forecasting asset-class returns.
John Bogle argues that investors greatly diminish their investment results by chasing historical returns. In his Little Book of Common Sense Investing (pp.93-97) he examines how the top ten performing funds over the three-year 1996 – 1999 period performed over the next three-years, over the complete six-year cycle, and how the investors in the funds performed.
The ten top performing funds, invested in high growth, technology and internet stocks, provided an average cumulative return of + 279% during the last years of the dot.com era. In the ensuing three-year bear market these funds produced an average cumulative loss of -70%. Over the full six-year period the funds managed a cumulative return of +13%.
The funds’ investors earned a -56% cumulative return over the six-year period. This means that most investors invested in the funds after the funds’ had recorded their superior performance
Investor return vs. fund return
|Top 10 performing funds||1996 – 1999||1999 -2002||1996 – 2002||Investor return|
Bogle also examines investor performance in Vanguard’s Growth and Value Index funds. The bull market in growth stocks during the last decade of the twentieth century resulted in the Growth Index gaining a cumulative return of +364% over the 1993 – 2000 period, compared to the +229% cumulative return of the Value index. Over this period investors poured 11 billion dollars into the Growth Index fund, compared to investing 3 billion dollars in the Value Index fund. Growth index returns plummeted during the 2000 – 2002 bear market, as did investor dollars. Over the 2001 – 2006 period the Growth Index fund experienced a net investor withdrawal of 850 million dollars, compared to a net inflow of 2 billion dollars in the Value Index.
The table below shows the time-weighted annualized annual compound return of both indexes as well as the dollar-weighted return that investors experienced.
|1993 -2006||Time weighted||Dollar weighted|
What if we could perfectly time the market?
Mark W. Riepe, from Charles Schwab, tests perfect market timing against four other investment strategies in his article, Does Market Timing Work?The study tracks the performance of five hypothetical long-term investors following one of the five following investment strategies
- Perfect timing: investing at the market low each year;
- Invest immediately: invest at the beginning of each year;
- Dollar cost average: invest in 12 monthly installments (also mirrors payroll installment investments in a 401-k type retirement plan);
- Bad timing: invest at the market high each year;
- Stay in cash investments: stay invested in treasury bills.
Each investor received $2,000 at the beginning of every year for the 20 years ending in 2012 and left the money in the market, as represented by the S&P 500 index.
The table below shows the ranking order of performance and accumulated wealth over the 1993 – 2012 period for each investment strategy:
|Dollar cost averaging||$79,510|
|Stay in cash investments||$51,291|
The totally unrealistic strategy of perfect timing will always occupy the top place in the ranking. The measured period was also one which included a realized equity premium return over cash investments.
The study then examined 68 rolling 20-year periods dating back to 1926. In 58 of the 68 periods, the ranking order was exactly the same. In only one period did investing immediately fall to the fourth ranking (in 1962 to 1981, a period of weak equity markets). However, during that period, fourth, third and second places were virtually tied.
The study concludes that “the best strategy for most of us mere mortal investors is not to try to market-time at all. Instead, make a plan and invest as soon as possible.”
- Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: http://ssrn.com/abstract=219228 or http://dx.doi.org/10.2139/ssrn.219228
- Barber, Brad M. and Odean, Terrance, Boys will be Boys: Gender, Overconfidence, and Common Stock Investment (November 1998). Available at SSRN: http://ssrn.com/abstract=139415 or http://dx.doi.org/10.2139/ssrn.139415
- Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance, Just How Much Do Individual Investors Lose By Trading? (May 2007). AFA 2006 Boston Meetings Paper; EFA 2005 Moscow Meetings Paper. Available at SSRN: http://ssrn.com/abstract=529062 or http://dx.doi.org/10.2139/ssrn.529062
- Barber, Brad M. and Odean, Terrance, The Courage of Misguided Convictions: The Trading Behavior of Individual Investors. Available at SSRN: http://ssrn.com/abstract=219175 or http://dx.doi.org/10.2139/ssrn.219175
- Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance, The Cross-Section of Speculator Skill: Evidence from Day Trading (December 31, 2012). Available at SSRN: http://ssrn.com/abstract=529063 or http://dx.doi.org/10.2139/ssrn.529063