A reader, Jay, left comments on my market timing experiment asking specifically about strategies that buy after a market drop, and sell after the market rises. The theory behind these strategies is to buy low and sell high.
I ran some experiments to test this approach. As in previous experiments, the investor decides each month whether to be invested in the S&P 500 or not. The goal is to avoid months where stocks drop in value. I ran the experiments on S&P return data from December 1990 to March 2008.
The first thing I tried was to assume that the investor would be invested in the stock market at the beginning and would proceed as follows:
1. If the money is in the stock market, and if stocks are priced at least 5% higher than they were one, two, or three months ago, then sell. Otherwise, stay in the market.
2. If the money is in cash, and if stocks are priced at least 5% lower than they were one, two, or three months ago, then buy stocks. Otherwise, stay out of the market.
The market timer’s compound annual return was only 3.2% compared to 11% for a buy and hold investor. How could the result be so bad? What happened was that the market timer jumped out of the market after prices rose and then waited for a decline that took a long time to come. In the mean time, the market timer was out of the market while prices rose.
Instead of just using 5% thresholds, I tried varying them over all combinations from 1% to 15%. That’s a total of 15*15 = 225 strategies. In every single case the market timer did worse than a buy and hold investor. The only time it was close was when the thresholds were set so that the market timer stayed in the market almost all the time.
As we saw in the version of my original experiment that took into account taxes, the market timer’s results compared to buy and hold are even worse if the money is invested in an account that isn’t tax deferred.
We could keep trying variations on this approach, but we’d run risk of creating a strategy that is tuned to old data but won’t work in the future like what happened in this April Fool’s joke.
All the market timing strategies I’ve examined fail in basically the same way. They stay out of the market too much of the time. The market rises most of the time and the odds are that the market will be up on average during whichever periods of time you choose to sit on the sidelines.