The Emperor Wears No Clothes, Part 5: Market Timing and Rebalancing
It is widely accepted in the investment industry that people cannot successfully time the market. Individual companies, markets, industries and investment styles (e.g., growth and value) seem to go up and down almost randomly and no one can successfully predict which way they’ll move. Numerous statistical studies confirm this accepted wisdom.
Consequently, many investment industry professionals eschew market timing. Does the industry take the market-timing conclusion too far, with resulting substantial cost and risk for you? Your faithful observer continues to court the industry’s wrath by questioning some of its basic premises in this continuing series of articles.
Exactly how do people define market timing? Most view it to be frequent buying and selling because you think that you know which way the market (or a stock) is moving in the very short term. This is dangerous (except perhaps for expert hedge-fund strategies). Success likely is more dependent upon luck than skill.
Industry professionals also view market timing in a larger sense - a deviation from your strategic allocation. For example, suppose your strategic allocation is 60% stocks and 40% bonds. You own them in exactly those percentages. The next thing you know, the stock market moves up, with the result that your equities now are 65% of your total assets (and bonds are down to 35% even though their values did not change).
Market-timing purists would say that you should immediately rebalance your portfolio when the market moves (meaning sell stocks back down to 60% and boost bonds back to 40%).
Rebalancing is good because it helps overcome fear and greed. It forces investors to sell hot performing asset classes when the natural instinct might be to buy more. Conversely, it makes you buy more of something that has declined in value even though you might fear them because they crashed in value. If you think of investing from a valuation standpoint, rebalancing also makes sense - buy when values are low; sell when values are high.
Delaying rebalancing means you are taking a larger bet on the stock market than your plan. Stick with your strategic allocation - end of story! Or is it?
One basic problem with frequent rebalancing is trading costs and, most importantly, tax consequences. If you are constantly taking money out of the appreciating asset classes to return to your strategic allocation, you are typically going to recognize short-term capital gains and pay Uncle Sam a large percentage of them.
Style boxes exacerbate the problem. In my example, not only do you have 5% too much in equities, but when you look closer you find that your large cap value stocks moved up 10%, small cap growth went down 6%, mid cap value held steady, etc. so that all your style boxes are out-of-kilter. The more sub-groupings you have, the more rebalancing you have to do, with more associated tax and other costs.
Maybe it’s better to let your strategic allocation get a little out of whack to avoid giving up such a large percentage of your returns. Giving a nod to the tax problem, progressive advisors have moved to quarterly rebalancing. But, that’s arbitrary, and not very satisfying. Unfortunately, it takes more active, customized management to deal with the tax issue, but that is not really possible for the consultants (who can’t readily influence the money managers) and it’s not part of most money managers’ business models (as I’ve discussed in previous articles). So, Uncle Sam tends to win in the rebalancing game.
Perhaps the most vexing aspect of the proscription against market-timing is that it can require the investor to take more risk than may be necessary. This requires some explanation because I am defining “risk” differently from most industry professionals. They define risk by reference to deviation from an index. If you own an index fund, you have no “risk” relative to the index even if it goes down 30%.
Modern portfolio theory balances out individual asset-class movements by using multiple asset classes that move somewhat independently, thereby smoothing the overall portfolio’s ups and downs. One asset class’ fall is tempered (hopefully) by another class’ rise (or at least, less severe fall). However, investors that I know perceive risk as the potential that an individual asset class (like stocks) might indeed go down 30%.
So, what if you think that the stock market, an industry or a style is undervalued or overvalued? Can you adjust your allocation tactically and reduce or increase your exposure somewhat from 60% in my example? “No,” say many industry professionals, “that’s market timing.”
Sorry, but that just doesn’t sound quite right. Following their logic, you had to continue to own growth (aka tech) stocks throughout the bubble; long-term bonds as interest rates hit record lows and appeared poised to move higher; your small targeted percentage of foreign stocks when those markets were undervalued and then experienced multiple years of record returns; etc.
True, no one can predict exactly when a market will turn, but if you’re really concerned with risk, it just makes common sense to reduce your exposure to overvalued assets. It’s simply a matter of recognizing that the risk-adjusted return expectation from those assets is unfavorable. You might lose out on some upside if the market doesn’t turn immediately, but you reduce your downside risk. Conversely, it also makes common sense to buy a bit more than your strategic allocation of something that seems really cheap.
I believe that investors who have the discipline to take and stick with a long-term view can significantly reduce risk and increase returns by modestly over- or under-weighting asset classes relative to strategic targets. But, many investment industry folks can’t fathom it because they think it’s market timing. Strangely, they applaud active managers making tactical bets within asset classes (e.g., over- or under-weighting an industry relative to the index or shortening bond terms when interest rates are expected to rise), but they can’t seem to stomach the same concept across asset classes.
Accurately forecasting short-term market movements is problematic. But, just like individual stocks, there are times when asset classes, markets, industries and styles depart substantially from reasonable valuations. That just might warrant making modest tactical moves away from your target allocation to reduce risk and increase overall returns. Speaking of timing, it’s time for me to sign off, for now.
Ross Nager is Senior Managing
Director of Sentinel Trust Company of
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