Artful Trader

How does market timing stack up against a buy-and-hold strategy?

During times of market volatility, investors using long-term strategies, such as buy-and-hold, may find themselves second-guessing their decision, especially when critics of index investing begin to claim they have a strategy that will capture the upside and avoid the downside in an asset’s price.

But unless one of these critics - often proponents of market timing strategies - can show audited returns or at least report global investment performance standards then it’s difficult to determine whether a strategy is valid and repeatable.

There’s no set time frame for long-term investing, as some trades can stay open for months and sometimes years, giving rise to very different management strategies.

 

Buy-and-hold vs market timing

One popular type of trading strategy is known as buy-and-hold. This is a form of passive investing that can provide broad access to markets at lower costs. Buy-and-hold aims to provide investors with a relatively stable portfolio over time, ignoring fluctuations.

Then there are the more active strategy types, one of which is market timing. This strategy involves an attempt by investors to beat the stock market by predicting its movements and buying or selling at the most advantageous time.

 

Paul Merriman’s buy-and-hold strategy

Paul Merriman, founder of Seattle-based investment advisory firm Merriman, is recognised as an authority on both buy-and-hold and active management market timing strategies.

For nearly 30 years, he’s been recommending what he describes as the “ultimate portfolio”: a low-cost equity portfolio consisting of the S&P 500 and nine other small and equal portions made up of US and international asset classes to help return and reduce risk.

“I’ve got loads of evidence to back up my confidence in this strategy. The strategy itself isn’t new, but as I do annually, I am updating the results to reflect one more year of data,” Merriman writes.

The issue, according to Merriman, is that tracking four indices isn’t diversified enough. He suggests that owning 10 asset classes instead will increase your total return.

“I’ve got loads of evidence to back up my confidence in this strategy. The strategy itself isn’t new, but as I do annually, I am updating the results to reflect one more year of data” - Merriman founder Paul Merriman

 

There is research to suggest that such buy-and-hold strategies can be beneficial. A study conducted by the University of California found that out of 66,400 portfolios the 20% of buy-and-hold investors, those that traded least actively, had an annual return net of trading costs of 18.5% compared to 11.4% return from the 20% of most active traders.

 

Day trading through the prism of market timing

However, others have suggested the benefits of a successful market timing strategy. When done successfully, day trading, can make anywhere between 0.5%-3% per day on capital, equating to 10%-60% per month, according to Chartered Market Technician and founder of Vantage Point Trading Cory Mitchell. Compare this to an average return of 10% per year for long-term traders, he says, and it stands out.

But predicting when to move in and out of a stock is difficult, as using technical indicators or economic data to gauge or time the market isn’t a sure bet.

As Mitchell writes on the balance, on top of the differences in potential returns, long-term investing and day trading require different time commitments, skills and personality requirements.  

“Both day trading and holding some long-term investments are important parts of a diversified investment strategy, although buying and holding investments offer a more passive form of income and wealth generation than the constant vigilance and work of day trading,” he notes.

“Both day trading and holding some long-term investments are important parts of a diversified investment strategy, although buying and holding investments offer a more passive form of income and wealth generation than the constant vigilance and work of day trading” - Vantage Point Trading founder Cory Mitchell

 

 

Market timing investors during the 2008 financial crash

As market timing relies heavily on actively buying and selling stocks in short timeframes, companies that claim to successfully time the market play a large part in investors’ decision-making process. Given the unpredictable nature of the markets though, these firms move in and out of the spotlight quite quickly.

Take the incessant recession fears for the US stock market for instance. There are a large number of bullish market timing investors who predict that stocks will maintain their upward trends.

MarketWatch’s Mark Hulbert – like many others – doesn’t agree with this sentiment. A number of investment advisors are considering the possibility of a US market meltdown on a scale as big as the 2008 financial crisis, Hulbert writes.

Back in August 2008 many of the market timers he had tracked under the Hulbert Financial Digest failed to warn their clients and instead gave optimistic advice, prompting what would turn out to be disastrous bets.

Investors who were ahead of a buy-and-hold ended up having higher average stock exposures into September 2008 than those who failed to beat a buy-and-hold.

As a result, Hulbert believes that investors should be cautious of taking cues from the market timing community, however, he also noted that they should also be wary of putting too much stock in one-off events and should be wary of attention-grabbing headlines such as “the stock market is going to crash”. After all market crashes are unpredictable.

 

Diversifying using buy-and-hold and market timing

Strategies that appear to be at odds with one another such as value or growth, or even schools of thought such as fundamental or technical analysis, can sometimes converge at key points. Buy-and-hold and market timing are no different.

Take Warren Buffet for instance. He is a well-known advocate of the buy-and-hold strategy, but in 2007 his firm Berkshire Hathaway sold its entire stake in PetroChina just months before its stock hit an all-time-high that boosted its market cap above $1tn.

On the other hand, Willian O'Neil, founder of William O’Neil + Co and Investor’s Business Daily, is known to use a short-term market timing strategy but held on to the stock Pic ‘N’ Save for seven and a half years until it peaked in mid-1986, marking a 10-fold gain.

Senior investment strategist at Morgan Stanley Dan Hunt believes that a mixed approach may be beneficial to all, whether conservative or aggressive, as “investors tend to care more about factors like risk, return and liquidity than they do fees”.  However, as quant trader and trading book author Michael Harris suggests, this kind of thinking may itself be obsolete. When considering relative risks of both buy-and-hold and market timing strategies Harris states: “Those who claim that buy and hold is risk-free are post hoc market timers.”

“Those who claim that buy and hold is risk-free are post hoc market timers” - quant trader & author Michael Harris

 

Written by

Free Report

A new frontier: The 12 energy stocks to watch

Get it now

Continue reading for FREE

Get instant access to this article and receive the latest market updates in our newsletter every week

  • 7000+ subscribers
  • Unsubscribe anytime

Related articles