The Volatility Effect & Following Your System

As always, CXO does an exemplary job summarizing a new paper out titled, “The Volatility Effect: Lower Risk without Lower Return“.

Bottom line (from CXO): In summary, investors overpay for volatile stocks over the long haul, most dramatically during bear markets.

In an unrelated note, Hulbert pens a great column on market newsletter “Douglas Fabian’s Successful Investing”.

Quote from the column:

“(Fabian’s) newsletter was started in the 1970s by his father, Richard Fabian, who based the newsletter on mechanically following the stock market’s 39-week moving average. The newsletter’s model portfolio was invested in stock mutual funds whenever the market was trading above its average level of the previous 39 weeks, and otherwise in cash.

Richard Fabian had many reasons to extol the virtues of his mechanical market timing system. One was that no one possessed all the information needed to come up with consistently good market timing predictions on their own; nor was anyone smart enough to correctly assess all that information even if they did have it at their fingertips. Fabian the father did not claim that the 39-week moving average system was perfect, but he strongly recommended that we adhere to some mechanical system. Otherwise, in the name of constantly trying to perfect our market timing model, we would in fact have no discipline at all.”

One of the biggest difficulties for many investors is simply following a mechanical system, especially when the system is underperforming or “out-of-sync” with the market. FundAdvice has some great columns on the subject of market timing. At the end of this column I reprinted the notes from a column Paul Merriman published over 10 years ago! Ed Seykota also has some pleasantly unique comments on his TradingTribe website as well.

The system that I presented in my paper is very similar to the Fabian system, but taken out to a monthly time-frame. Indeed, the timing model only outperforms a buy and hold allocation about 50% of the time (by essentially chopping off the long and short tails of the distribution). In the historical backtest, there were stretches of mutiple years where the timing system would have underperfromed the buy and hold allocation. This is precisely why many have difficulties following a mechanical system, often at possibly the worst possible time.

Hulbert follows later in the article,

“Fabian the son took over the reigns of this newsletter in 1992, and has gradually strayed away from adherence to the 39-week moving average. The past year has been typical: The 39-week moving average turned bullish in the middle part of last August, for example, and remains bullish to this day. But at no time since then has Fabian allocated any part of his newsletter’s model portfolio to a diversified domestic equity mutual fund.

This straying has exacted a big toll, according to the Hulbert Financial Digest’s calculations. If Fabian the son had simply followed the 39-week moving average system to switch between an index fund and cash, since 1992 his newsletter would have produced a profit more than two percentage points per year higher than it actually did. Its performance on a risk-adjusted basis would have been even higher.”

Exerpt from “Do you have what it takes to be a successful market timer?“,

Here are six questions to help you determine if you have what it takes. (Long-time Fund Exchange readers may recognize this topic from an issue we published five years ago.) There are no right or wrong answers, only what’s true for you.

Six questions

1. Do you have the necessary perseverance?
Timing can get you in real trouble if you try it for awhile, become discouraged and then abandon your plan in favor of something you find more palatable. If you let your feelings guide you, you’re likely to bail out of a timing strategy at the very worst time, when your investments are down. Can you adopt a strategy and stick to it for the long term? Can you follow the system regardless of how you feel about it and regardless of what’s going on around you? Can you resist the temptations to act on impulse? Can you ignore the many “hot tips” you may come upon every week?

2. Are you independent and self-assured enough to resist the temptation to constantly look over your shoulder to see how somebody else is doing?

There aren’t many certainties about investing, but here’s something I can guarantee: no matter how your investments are doing, there will always be somebody who has recently outperformed you and seems to have struck it rich. Nervous investors constantly look over their shoulders, hoping to find somebody who has found “the one true path” to wealth. That path is a myth, and nervous investors don’t make good timers. Confident, successful investors know what they want and need, adopt a strategy to achieve their objectives and stick with that strategy regardless of what others are doing. If your goal is to increase your assets by 10 percent a year, and a timing system lets you achieve that, can you be satisfied even when other people are making 12 percent or 15 percent or even 20 percent? If so, you may have what it takes to succeed as a timer.

3. Can you accept that your portfolio will underperform the market?

This should be obvious, but you would be surprised to know how many people forget it. A timing system is not designed to produce the same returns as the untimed market. When you outperform the market, you are likely to be pleased. But your pleasure may be mild compared with the fury or betrayal you can experience when your portfolio is under-performing and when your timing system produces a losing trade. That’s especially true when you just “knew” that the signal you got from your system was the wrong thing to do.

4. Can you accept that your timing system will be imperfect?

Imperfection is one of the media’s biggest criticisms of timing. When you are underperforming and experiencing losing trades, that media criticism may shake your confidence. The media often says market timing requires you to be right twice: when you buy and when you sell, in contrast to a buy-and-hold approach in which you have to be right only once: when you buy. Most of the time, you can count on your system to get you into or out of the market “too soon” or “too late” to catch the tops and bottoms. If getting out at the very top and getting back in at the very bottom are your goals, timing is guaranteed to let you down. And if that failure will drive you nuts, think twice before embarking on a timing strategy, because what you will perceive as timing mistakes will erode or destroy your willingness to follow the discipline. Your goal should not be to achieve perfection. It should be to put the probabilities on your side. And a good timing strategy will do that.

5. Can you ignore the mass media?

Almost unanimously, the popular press seems to have a blind spot when it comes to timing. They say timers are misguided, and this view is widely echoed by the mutual fund and brokerage industries. Can you pull out of the market when everybody else is either getting in or already making money? Can you get back in when your friends, colleagues, the media and possibly your own gut are telling you it’s a dumb idea?

6. Are you decisive?
Some people stew and fret and delay making decisions, even when they are convinced they should do something. They are unlikely to be successful timers. Successful timing requires quick action to move into and out of markets. One of the most obvious truths about timing (and one of the most widely overlooked) is that by the time your friends, your colleagues, your gut and the experts all agree on what you should do, it’s already far too late for you to extract the maximum opportunity from it. If you usually take lots of time to make decisions, this is not a suitable arena for you.

10 Keys to Successful
Market Timing

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.