How market timing reduces volatility

Many investors regard market timing as an attempt to make more money on investments. Occasionally that happens, as we shall see.

But that’s not the point of timing. Timing’s real purpose is to reduce investment risk, and you can count on timing to do that.

Why am I so confident of this? Simple: Market-timing systems get you out of the market and into money-market funds from time to time. Every day you aren’t invested is a day when you don’t face the risk of loss.

If timing won’t make you more money, why do it? If you’re timing an investment, you should realistically expect that your losses will be lower during the worst of times and your gains will be lower in the best of times.

That’s theory. What about the facts?

To evaluate how market timing has performed in the 21st century, I decided to find out how a well-diversified all-equity portfolio performed in the 10 calendar years from 2005 through 2014 — with and without market timing.

I found that, as expected, timing substantially reduced the risk of this portfolio, measured by standard deviation, decreasing it from 18.3% (buy-and-hold) to 11.2% (timing).

Also as expected, timing substantially reduced the worst-year loss from 41.7% (buy-and-hold) to 18.3% (timing). And, according to the standard playbook, timing’s best year had a lower gain (32.1%) than that of buy-and-hold (36.3%).

These results represent actual performance after expenses and fees and come from the investment advisory firm for which I used to work (and with which I have no further affiliation except as a client).

Table 1: Results of All-Equity Portfolios (2005–2014)

Source: Merriman Inc.

As you can see, there’s a third line in that table: “Combination.” It shows the results of my preferred approach, which is to diversify further by having half a portfolio governed by timing and the other half invested without timing.

This golden combination gives me added peace of mind. I know that in many years, buy-and-hold will outperform timing; and in other years, timing will outperform.

Even though there’s no way to know in advance which approach will do better, by having half my money in timing and half without it, I know that I’ll always get the benefit of whichever one is doing better.

As you would expect, the combination’s best-year and worst-year results fell between those of buy-and-hold and timing. The same was true for volatility.

These results tell me that the combination delivered additional peace of mind with no reduction of performance at all.

To my way of thinking, that’s a win-win result.

Of course, market timing isn’t the only way to reduce investment risk. It isn’t even the best way.

The best way, at least in my view, is to own bond funds as well as equity funds. If stocks are the engine that moves your portfolio forward, bonds are the brakes that help keep things safe and sane.

For many retired investors who are concerned about risk, I believe a 50/50 mix of stock funds and bond funds is a good answer. The performance won’t be so robust, but the losses will be much less dramatic. This is similar to the mix I have in most of my own portfolio.

As you might guess, it’s just as easy to apply market timing to bonds as well as to stocks.

Accordingly, I examined how a 50/50 balanced portfolio held up from 2005 through 2014 — with and without timing. The bond component is a combination of TIPS and short-term and intermediate-term government bonds.

As it turned out, the 10-year compound returns on a 50/50 portfolio were nearly identical: 5.7% without timing and 5.6% with timing.

Table 2: Results of 50/50 Bond/Equity Portfolios (2005–2014)

Source: Merriman Inc.

These numbers represent only a single 10-year period and will never be duplicated exactly again. Still, they provide statistical evidence of the benefits that are possible when you adopt market timing and when you split your portfolio between timing and buy-and-hold.

Two important points should not be overlooked:

• Market timing is emotionally difficult and should not be undertaken lightly.
• If you commit to timing, don’t manage it yourself. Hire a professional.

If you get past those hurdles, I’m confident timing can reduce the volatility of your portfolio — and that there will be periods when you’ll be glad you had at least some of your money governed by it.

For more on this topic, check out my podcast, “10 Things You Should Know About Bear Markets.”

Richard Buck contributed to this article.