02.20.09

New evidence against market timing

Posted in All Categories at 10:14 am by Michael Goode

See original synopsis on the CXO Advisory Group’s blog and see the original academic article (”Data Snooping and Market Timing Performance“) that just came out.

Conclusions of the paper:

“In isolation, over the entire 1980-2007 sample period, the best-performing simple (complex) rule outperforms a buy-and-hold strategy by an annualized 2.93% (3.18%).

Over the the full sample period, no simple or complex market timing rule significantly outperforms a buy-and-hold strategy after correcting for data snooping bias.”

For those who are not statisticians, data-snooping is what happens when multiple researchers look for patterns in a large set of data. With everyone looking for ways to time the market, people are bound to find ways that would have worked in the past, just by chance alone, if they look hard enough.

Also, for those of you who say, “but I’ve been using X market timing system for 3 years and it works,” you are falling prey to a failure to use a strong self-sampling assumption (explained in the Wikipedia article on the Anthropic Principle): “Each observer-moment should reason as if it were randomly selected from the class of all observer-moments in its reference class.” Instead, you are reasoning as if the market crash had to happen and your market timing system would have worked to predict it.

Of course your market timing system has worked in the last two years! This has been one of the worst periods ever in a stock market! Any system that was not fully invested in stocks would have outperformed the market, no matter how random or useless it was. For example, if I decided to go to T-bills every time a movie with at least two “A”s in the title hit $50m in box office receipts, and got back in when a movie with two “B”s hit $50m in box office receipts,  I would have outperformed the market! Yet when the stock market rises again, all market-timing systems will underperform (because they will hold cash at various times). And can you be so sure that your system will do decent enough to keep a future bull market from wiping out the system’s relative bear-market performance?

I find it amusing that everyone is buy-and-hold at the top of the market and a market timer at the bottom. Even assuming only moderate population and productivity growth in the United States, our stock market is posed to offer very nice risk-adjusted returns in the next twenty years.

Let me add an analogy to bolster my argument in the last three paragraphs:

Imagine you are a lonely guy (not blessed with the perfect wife, unlike me) looking for a date. You go to a bar / church / cafe / anti-bailout protest and you ask a woman out on a date. You use a funny joke / pickup line. She says yes and agrees to go on the date with you. If you conclude that the pickup line is what did it, when previous pickup lines never worked, you draw the wrong conclusion. What you need to do to conclude that the pickup line worked is to ask other women out using the pickup line and see if it works then. Otherwise, you are confusing luck (or maybe just good chemistry, shared interests, etc.) for the success of your pickup line.

Likewise with market timing in a downturn. The downturn makes everything look good that wasn’t in 100% equities. You need to test your system (out of sample, of course) in a bull market to be sure that it actually works.

Permalink