Successful Market Timing

Via World Beta:

If you have the emotional makeup for it, timing can reduce your risks and enhance your returns. If you’re satisfied that you have what it takes to be a market timer, here are the best tips I know for doing it successfully. They aren’t necessarily listed in order of priority. In fact, I suggest that you regard each one of them as the top priority.

1. Use mechanical strategies.
Timing financial markets is already plenty hard without worrying about making predictions or (even worse) thinking you have to decide who is right when smart economists and savvy analysts make conflicting forecasts and draw different conclusions. If you leave the final decisions to subjective factors, you will never be sure what you are supposed to do at any given moment. That will cause you anxiety and delay. And you’ll have a system you can’t count on. Rely primarily on trend-following systems that are based mainly on trends that are impacted by actual prices in the market. There’s nothing speculative about prices. They reflect what buyers and sellers are doing, and that’s about as reliable an indicator of the direction of the market as you can find.

2. Do not — repeat DO NOT — pay much attention to the effect of every trade.
The majority of individual trades will be irrelevant to your long-term results. If you feel you must focus on each trade and agonize over what it means, that’s a sure sign you are not cut out to be a successful timer. Dwelling on each trade is a sure way to drive yourself nuts, and it won’t improve your results at all.

3. Use timing systems that are right for you and your temperament.
The perfect strategy for you will match your time horizon, will respect your emotional needs and will operate within your tolerance for risk and change. There are short-term systems that trade frequently, long-term systems that trade infrequently and intermediate-term systems that typically trade two to six times a year. Over long periods of time, no group has an inherent return advantage over the others. But the practical and emotional differences are important. If you have a strong desire to perform closely in synch with the market, use short-term systems, which are good at quickly reacting to today’s highly volatile market swings. However, short-term systems demand that you make many trades, and each trade has potential tax consequences unless you are investing in a tax-sheltered account. The volume of trades demands a lot of attention, produces a lot of paperwork and tests the patience of many mutual funds, which sometimes won’t accept accounts from very active timers. If on the other hand you have a strong aversion to whipsaws, you can use long-term systems. But doing so will sometimes make you wait for a move of 20 percent or more before you buy or sell. For the best compromise, do as we do: Use intermediate-term systems. This level of activity is likely to be accepted by most mutual funds and is not too demanding emotionally.

4. Use multiple timing systems, stick with them and let them act independently in your portfolio.
Even the most productive system from the past may be a mediocre performer in the future, and the reverse could also be the case. We use four U.S. equity timing models, each of which governs 25 percent of our portfolio. We have faith in the systems as a group. But we don’t have enough faith in any one system to let it govern the whole portfolio. You shouldn’t either. Just as you should not chase recent performance in your choice of mutual funds or asset classes, do not chase recent high-flying timing systems. One of the smartest timers in this business, a fellow newsletter publisher whose work I respect, has averaged about 9 percent over the past decade. He chooses good timing systems, which have produced average returns of more than 18 percent before he adopts them. But he doesn’t stick with those systems. Whenever the system he has been using disappoints him, he finds another one that would not have done so, based on real or hypothetical past performance, and then he switches to that system. In theory, this may seem like a valid way to search for the very finest system on the planet. But in truth, such “superstar” timing models simply do not exist. They are a myth. Good performance one year doesn’t mean anything about performance the next year – not anything. This is one of the hardest facts for investors to accept, but it’s true. Therefore, we believe your best bet is to find several robust timing models and stick with them.

5. Remember that whether you use a buy-and-hold approach or market timing, asset allocation is the most important investment decision you will make as an investor.
Use many assets or asset classes that move up and down at different times and at different speeds. Include international diversification, whether you invest in equities, bonds or both. Just as you never know which timing model will be the star performer in a given quarter or year, you never know which asset class will be the overachiever and which will be the laggard.

6. Follow your systems and your strategy.
Put them into action without fail and without exception. Remember this Chinese proverb: “He who knows but does not act, still does not know.” If you do only one thing right and everything else wrong, make sure this is the one thing you do right. This is the most essential key of all. If buying diet books and exercise equipment took off pounds, obesity would not be a major health concern. You can devise the greatest portfolio in the history of investing, but it will do you no good unless you commit your money to it. The greatest timing models do you no good unless you apply them. Therefore, do whatever is necessary to get it done.

7. Before you start timing, take off the rose-colored glasses, if you are wearing them.
Focus in advance on the difficulties you can expect as well as the ultimate rewards you hope to achieve. Accepting the rewards of success will be easy. But you’ll never get to the finish line unless you can deal with the hurdles along the track. Know the level of interim losses you are likely to encounter with your strategy, and make sure you are willing to accept them. In the early 1970s, buy-and-hold investors in the Standard & Poor’s 500 Index suffered a 39 percent loss in one year. Even timing can be ugly. In our Worldwide Equity strategy, all our back-testing has failed to produce a decline as high as 15 percent in any 12-month period. Yet we believe that any strategy with the potential to produce returns of 13 to 15 percent a year also has the potential to lose 15 percent in a year, so that’s the figure we use when we project the expected worst-case scenario. Bottom line: Do not expect magic from any timing system.

8. Give timing enough time to work. In the short term, anything can happen.

In the long term, if you have chosen a strategy carefully and you follow the discipline, you should be rewarded accordingly. But how long is long enough? There are two places to look for the answer. The first is in your own psychology. Do you normally undertake long-term projects or strategies, comfortable knowing that you’ll have to wait for any payoff? If so, you may be a good candidate for market timing. But if on the other hand you are usually quick to judge the success or failure of something you start, and if you need instant gratification, you’ll probably have trouble being a successful market timer. The second place to look for the answer is in statistics and history. Arm yourself (or have your manager do this for you) with the past statistical performance, either real or hypothetical, of your proposed investment. Over the longest period for which you have data, determine the depth of the largest drawdown. Find out how long it took to return to break-even. One of our most aggressive timing programs, which we call by the shorthand of +2 to -1, meaning it attempts to double the performance of large U.S. stocks when the market is rising and to do the opposite of the market during declines, once took nearly two years to recover from a 20 percent drawdown. Are you prepared to endure that in order to make returns of more than 20 percent? Here’s an even tougher example of the extraordinary patience required of investors: In 1973 and 1974, the S&P 500 declined by 44.9 percent. The index eventually regained its pre-decline level. But it took 66 months for some investors just to break even. Unless you are sure you’d stick with a strategy through the longest historical drawdown for which you have data, don’t embark on that strategy.

9. Unless you are absolutely committed to being a market timer, use both timing and buy-and-hold.
This gives you two non-correlated approaches that will have differing results in any given period. Over long periods, carefully chosen investments in similar assets may generate similar returns with buy-and-hold and market timing. But in the meantime, the average of the two may give you lower losses, less risk and (perhaps most important) less anxiety than either market timing or buy-and-hold alone. This combination may be more appealing to many people than the peaks and valleys of each approach separately.

10. Make sure you understand in advance the realities of market timing.
And make sure you are prepared for them. I cannot emphasize this point too much, so I hope you’ll read the following overview. If you invest money that’s governed by timing and you’re surprised by everything that happens to your investment, you will always feel off balance. You’ll come to dislike and distrust timing. And even if you follow your system, timing will produce anxiety for you. That is just the opposite of what it’s intended to do.

Why Markets Make Mistakes

Via Simoleon Sense:

Introduction (Via SSRN):

The research described in this article calls into question the assumptions of rationality, transparency, efficiency, and homogeneity on which many models of markets are based (see for example Samuelson 1948; Bass 1969; Fisher and Pry 1971, Malkiel 1973). The classic models assume, at least implicitly, that decision makers understand the structure of the market and how it produces the dynamics which can be observed or might potentially occur. Are these models acceptable simplifications, or can they be seriously misleading?
This article explains why markets routinely and repeatedly make “mistakes” that are inconsistent with the simplifying assumptions and often produce disastrously wrong business decisions. The undesirable outcomes could include vicious cycles of investment and profitability, market bubbles, accelerated commoditization, excessive investment in dead-end technologies, giving up on a product that becomes a huge success, waiting too long to reinvent legacy companies, and changes in market leadership. The article illuminates the effects of bounded rationality, imperfect information, fragmentation of decision making, and extrapolating past trends.

Click Here To Learn Why Markets Make Mistakes

The Problem with Securitization

James Kwak from Baseline Scenario:

The boom in securitization was based on investors’ willingness to believe what investment banks and credit rating agencies said about these securities. Buying a mortgage-backed security is making a loan. Ordinarily you don’t loan money to someone without proving to yourself that he is going to pay you back (or that the interest rate you are getting will compensate you for the risk that he won’t pay you back). The securitization bubble happened because investors were willing to outsource that decision to other people — banks and credit rating agencies — who had different incentives from them.

Are investors going to go back to that mindset? Do we want them to? It seems to me the rational investor response is this: “I have no idea what is in those securitization trusts. I don’t trust the banks, since they are taking fees out of each deal. I don’t trust the credit rating agencies, since they are being paid by the banks, and don’t have enough staff and expertise to do the job properly. I don’t trust the models, because they’re wrong. There’s no way I can do the analysis myself. So I’m not buying.”

Read the full post here

The Economics of Models

Via Baseline Scenario:

One thing that seems clear is that risk models that are designed to function in normal market conditions should not be relied upon to predict outcomes in times of crisis. On this account, VaR doesn’t kill banks; executives who don’t recognize the limits of VaR kill banks. As Bookstaber put it, “one has to look beyond VaR, to culprits such as sheer stupidity or collective management failure: The risk managers missed the growing inventory [of risky assets], or did not have the courage of their conviction to insist on its reduction, or the senior management was not willing to heed their demands. Whichever the reason, VaR was not central to this crisis.”

Given that everyone is agreeing sophisticated risk models are worthless in crises, it seems particularly remarkable that regulators allowed some banks to use their in-house models in determining their own capital requirements – since one of the purposes of capital requirements is precisely to provide a cushion that protects banks (and their creditors, and taxpayers) in the event of a crisis. The obvious solution is that regulators should rely on cruder constraints, such as an absolute limit on leverage that banks cannot arbitrage around (one of the recommendations of Treasury’s recent white paper on capital requirements, which we discussed here), or periodic stress tests that estimate how bank asset portfolios will perform in a real crisis.

But there is a more interesting question to ask as well: why did VaR become so popular? It’s important to remember that competition among models is shaped by the human beings who create and use them, and those human beings have their own incentives.

David Colander made this point about economic models: the sociology of the economics profession gave preference to elegant mathematical models that could describe the world using the smallest number of parameters. “Common sense does not advance one very far within the economics profession,” he says.

A similar point can be made about VaR models. Sure, maybe all the financial professionals who design and work with VaR know about its shortcomings, both mathematical and practical. But nevertheless, using VaR brought concrete benefits to specific actors in the banking world. If common sense would lead a risk manager to crack down on a trader taking large, risky bets, then the trader is better off if the risk manager uses VaR instead.

Read the full post here