About using Market Timing in Investment Management.

“Market timing” is just investment jargon that means trying to decide where a market or a particular security currently is, where it may be going, and when. Trying is the key word here.

Market timing, including all forms of charting, waves, and "technical analysis," doesn't work because nobody can predict the future, period. The future prices of stocks, asset classes, or any market (e.g., interest rates), cannot be predicted from charts of past prices, wave theories, econometric models, historical trends, oscillators, computer programs, statistical relationships that worked in the past, nor any other method. All financial markets move in response to millions of participants acting upon random daily news, by trading securities, none of which can be predicted at all.

To win at the market timing game, one needs to be correct more than 75% of the time to break even with mistakes, transaction costs, and taxes¹. Because few people have shown a consistent track record of being correct even more than they are incorrect, this practice is just an exercise in futility. Only one in four timers beats the market two years in a row, and only one in eight three years in a row². Results of empirical studies also show that only one in 37 mutual funds showed any benefit from market timing.³

1: The New Finance, Robert A. Haugen, page 13
2: Managing Investment Portfolios, Donald L. Tuttle Chapter 13, page 36
3: Modern Portfolio Theory and Investment Analysis, Edwin J. Elton and Martin Gruber. Page 653

The main reason market timing doesn't work is because you have to make four decisions every time it's used. You would have to be correct in three calls on average to make high enough of a return to justify the costs and risks of being wrong in just one of the four calls.

First, you have to pick what's "up" (and will go down in the future, or why sell it?) for the sell decision to raise the money to buy what you think will go up in the future. Then you need to know when to sell it (so you don't sell when it's down). Then you need to know what's "down" (and will go up in the future, or why buy it?), and when to buy it (so you don't buy when it's up).

All it takes is to be wrong on one of the four calls to wipe out the profits from other three calls. The chances of all of this netting out to a profit on average, after taxes and trading costs, are slim to none (and Slim left town).

If someone could market time with as little as 65% accuracy, they'd be on the front page of every newspaper every day, and there would be more than just a handful of firms practicing market timing. Everyone you see on TV, or in magazines / newspapers, predicting the future is just guessing.

The reason there's only a small handful of market timing firms at any point in time, is because they fold up and go under at roughly the same rate as new firms are formed.

Some are just trying to convince you to buy the stocks, ETFs, or asset classes they just bought so they'll go up, and they can then sell out at a profit. Why else would their clients, who are paying stiff fees, tolerate their money manager going on TV and giving away free advice they have to pay for?

It's their job to convince you they can predict the future so they can move their products and sell their services. But over time, their "mistakes" will lose you way more money than their periodic lucky calls will make you money.

This is all you need to know about market timing, technical analysis / charting, and what to believe from the financial media (when it comes to predicting the future) to be a successful investor. It's just as simple as that.

Security Selection

“Security selection” is investment jargon that means choosing one investment over another. Stock and ETF picking is the most well known form of security selection.

The most-common example of security selection is just thinking that something will “go up.”

Most thoughtful security selection decisions are made within the same asset class - in other words, deciding which stock, bond, or mutual fund to purchase compared to others of the same type.

But most are random guesses based just on intuition and wishful thinking of quick and easy profits. This works better than market timing, but still, on average, it doesn't work (it only "works" when the whole market or that asset class is going up).

Here's the difference between security selection and asset allocation: Deciding to have 10% in large-cap U.S. growth stocks is an asset allocation decision. Choosing AMD over Intel, to represent this 10%, would be a security selection decision.

Security selection (e.g., stock picking) can only be done effectively by large institutions, like mutual fund managers, who concentrate all of their efforts on a small segment of a market (like tech stocks). Even then, most have marginal records, unless you know how to find the good ones by screening mutual funds.

Also mutual funds can only do it well if they stay focused on one asset class. That's why mutual fund objectives like Blend, Global, Balanced, All-cap, Target, Life Style, Life Cycle, Hybrid, and Growth & Income, seldom get good results. They just can't maintain the focus needed to be superior stock pickers because they're trying to do too much at once (by working with more than one asset class).

There are just too many stocks, too much news, and it all happens way too fast to cope with. Company news comes out of nowhere and could bring a stock down by half in days - before anything can be done about it. That's way too risky, so individuals, and financial advisors that manage money for clients, should not waste time trying to pick stocks (or ETFs). But they love to do it because it's fun to be a "player on Wall Street." It's just the one and only fun part of an otherwise boring and tedious job.

We practice only a little bit of security selection by using Morningstar database software to screen mutual funds. This helps us find ones we like and eliminate those we don’t like. We use security selection techniques here because mutual funds that are consistently highly-ranked in their category over short, intermediate, and long periods of time tend to remain highly ranked over time. In other words, our elaborate mutual fund screening process has evolved since the late '80s to the point where we can find adequate predictive value of about a year and an half.

The managers of mutual funds that pass our screens just had (and hopefully will continue to have) a superior way of selecting securities and deciding when to buy and sell them (market timing). These managers devote their full attention to security selection and market timing in a narrow segment of a market. We feel keeping this narrow focus is about the only way security selection and market timing can produce benefits after transaction costs.

Here's an example: Enron. CSFB's analyst had a strong buy recommendation on Enron just five days before it declared bankruptcy on 2 December 2001. JP Morgan - just four days. JP Morgan and Lehman Brothers analysts were both "locked into their buy ratings" because they were involved in the Dynegy merger (investment banking relationship conflict of interest). All three major bond rating services (Moodys, Fitch, and S&P) had above investment grade ratings on Enron's bonds, also just four days before they declared bankruptcy.

In 2008, the legendary Warren Buffet, supposedly the "World's greatest investor ever," lost about 44% of his Berkshire Hathaway's money in a year. In 2011, news of their unethical and self-enrichment shenanigans came out.

Even gurus like Jim Cramer that have their own TV show are just guessing. On the first week of March 2008, he said to not sell Bear Stearns, after reading a concerned viewer's letter which read, "Should I be concerned about Bear Stearn's in terms of liquidity problem, and get my money out of there?"

Cramer replied in his usual tirade, "[sic]No no no! Bear Stearns is fine.... Don't move your money from Bear, that's just silly... Bear Stearns is not in trouble!" The stock went from $80 to $2 overnight one week later (and was $171 a year before). Five days before this rant, Cramer ranted, "Bear Stearns is not in trouble!"

And seven weeks before it went belly-up, "I'm asking people watching this video to buy Bear Stearns. Now Bear Stearns acts much better than it should... now that's just intuition. And I don't want to put much faith into intuition, but I have had good intuition over 29 years of investing. The Bear franchise, you know what, for $69 I'm not going to give up the thing. And I just think that this one has a very big upside and a very limited downside here."

These are the "best" stock pickers, so think how well your local Joe Blow stock (or ETF) picker is going to do. The short answer: Way way way worse.

These kinds of things alone should be enough to convince people that stock pickers are not to be relied upon for anything but recommending stocks they already own (so they will go up so they can sell at a profit, while non-fee-paying-clients who bought it on their TV recommendations are left holding the bag), and doing everything possible to protect the huge fees earned on investment banking relationships. They are not always out looking for good stocks for clients to buy, and there's too much conflict of interest, so they should not be relied on to pick your stocks.

You don't need to spend hundreds of hours researching this - just look at any market timer, technical analyst, lone-wolf stock picker, private money manager, or brokerage firms' long-term track record (over three years) and see for yourself. They may have had a lucky year here and there, but it's the long-term average that matters (see how much they lost compared to the S&P 500 since 2000, if it's more than a couple of percent more, then that's a big problem).

When it comes to individual stock picking outside the environment of large institutional investors that focus on a small segment of a market, like mutual funds, most empirical studies have shown that security selection techniques add little value. Some reasons for this are:

• There are just too many stocks to pick from. With 10,000+ stocks just in the U.S., where do you start?

• There's too little information available from the companies, most are just estimates, and it’s quickly outdated. As Enron and WorldCom showed us, even data right from the firm can be "wrong" for many reasons.

• There's usually not enough time to do an adequate analysis of all of the important facts.

• Things change on a daily basis. News could come from anywhere, anytime, and could change your gains into huge losses in just a few hours. The point is, a stock could turn before you find out and have time to do something about it. Mutual funds typically own so many stocks that even if one got torpedoed into worthlessness overnight, the fund would still have most of its value.

• The only people who have the data needed to forecast a stock's future price are the people who work at / for / or with the company - and they can't tell anyone because they'd go to jail by breaking insider trading laws. Everyone else is just guessing with incomplete pieces of outdated estimated data. Mutual funds don't have inside information, but have the resources to be the best at guessing (just buying a good software package for screening stocks runs around $25,000 per year).

• The main reason the art of security selection is so difficult is because so many qualified people are in the market on a daily basis doing essentially the same things. So in effect, these folks have actually become the market. It’s hard to beat yourself over time, so last year’s superstar just becomes this year’s dog by making a few little mistakes.

• It's humanly impossible to find the time, money, and other resources needed to both manage clients' assets in a way to get the results they need and expect, and keep up with thousands of stocks or ETFs on a daily basis. They may get lucky here and there, but over time the losses of their "mistakes" will greatly outweigh their lucky picks. Successful professional stock pickers either make their own mutual fund, or are hired by mutual funds, because that's where the real fun and money is.

• The biggest problem with security selection is knowing when to sell. Nobody likes selling a "great company." You don't need to be a CFA Charterholder to know when a stock you've been following will go up. Just wait for accelerating earnings growth - stocks usually go up after that. But that's usually when they are at peak prices.

This is usually when people buy because they feel "it's safe now that it's going up." But that's usually when it's time to sell. Nobody wants to sell anything that's going up, so they wait to try to get a few more bucks out of it. That's when it goes back down before they can sell it. Then the investor goes into denial - which usually results in holding it forever because they don't want to take a loss.

So you want to buy stocks when the news is bad, and sell them when the news is good. But this is the exact opposite of what most investors actually do in the Real World.

• Recommendations by "research departments" of major brokerage houses rarely get superior results because their stock picks are frequently biased toward firms they have investment banking relationships with (they are under constant pressure to move stock and bond inventory on the deals their firm underwrote).

• There are also conflicts of interest with analysts who give stock recommendations. They can only give "buy" recommendations, or the company will get mad and stop giving them information. And they're not going to tell you when it's time to sell a stock their firm has other (investment banking) relationships with, because they'd get fired. And they don't like downgrading stocks because it makes them look stupid for recommending it in the first place. The regulators are making progress with this, but it's still decades off.

The bottom-line is that even the best stock pickers tend to lag the market over time. The longer the time frame, the more stock pickers (and market timers) lag their benchmark indices and/or the markets.

For these reasons, we don’t think security selection should be emphasized in investment portfolio management (either) for sane rational investors investing for critical long-term goals, like retirement.

Asset allocation is the only thing that works for investors who manage money either for themselves, or for clients. It's the art and science of determining how much of the dozens of asset classes people should own (based on their life situation). Then one just holds the mix until a major life factor changes.

Then you just find good mutual funds to represent each asset class. Mutual funds are best suited to market time and pick securities (somebody has to do it unless you want to use index funds, which by definition just gets average results).

Yes, asset allocation is very boring, and you're guaranteed to never double your money in one year, but it will also get the best long-term results.

There is a lot more to read like this in the Money eBook.

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