Selecting a long term investment plan and maintaining it over time is the key to investment success. However, market conditions that are constantly changing can make this difficult to do. The current bond market environment, where rates are exceptionally low and seem likely to rise eventually, can tempt investors to deviate from their established investment plan by purchasing securities shorter than those that they would typically consider. These investors are engaging in market timing, although they may not even realize they are doing so.
Trying to Time the Market
At first glance, market timing can appear to be a viable investment strategy. In fact, accurate market timers could generate returns in excess of those available to adherents of a more consistent investment strategy. Furthermore, the benefits of successful market timing go beyond financial rewards. There is a tremendous amount of emotional and psychological satisfaction that comes from correctly predicting market movements. The feeling that “I’m smarter than the market,” is quite tempting and very appealing. Often, these non-monetary rewards are so great that they cause a market timer to remember fondly those occasions when they have correctly predicted market moves. These instances are then used to justify further attempts at market timing. Unfortunately, this often leads the investor to avoid a realistic and rational measurement of the portfolio’s long term performance.
If the investor did measure their portfolio performance against a market benchmark, they would probably find that over time their portfolio had performed relatively poorly. That is because, while market timing is a concept that sounds good in theory, it is nearly impossible to execute in the real world. “Trying to predict (the market’s) direction over the near term is an exercise in futility.” These words were spoken by the legendary mutual fund manager Peter Lynch, one of the most successful investors of all time.
The Difficulty of Interest Rate Forecasting
When it comes to investing in the bond market, successfully forecasting future interest rate movements should result in superior long term investment returns. However, in order to be successful, the prognosticator must not only correctly determine the direction of interest rate movements, but also their magnitude and timing. The majority of academic studies, as well as many market participants, agree that doing this on a consistent basis is virtually impossible.
To make matters even worse, successful market timing requires the prognosticator to correctly forecast the market, not once, but twice. A market timer must successfully predict a market movement, which prompts them to deviate from their established investment strategy in an attempt to capture additional returns. Then, the market timer must make another correct prediction in order to decide when to return to their chosen long term investment strategy.
If the odds of correctly timing a market movement are 50/50, then the chances of correctly entering and reversing a market timing trade are 25%. The chances of correctly executing two market timing trades are 6 in 100, and the odds are only 1 in 1000 that a market prognosticator will be able to correctly time their entry and exit from the market on five separate occasions (this is a failure rate of 99.9%). While some market timers might argue that their odds on any given trade are greater then 50/50, many studies indicate that this is unlikely to be the case. In fact, academic surveys that measure the predictions of many of Wall Street’s leading economists and market strategists indicate that their actual success rate at predicting interest rate movements is less than 50%. In other words, some of the world’s most successful economists are less accurate than a coin flip.
Finding Long-Term Success
In order to enjoy long term success, an investor must have a process that works and that is repeatable. While correctly predicting one, or even two, or perhaps even ten market movements may be possible, an honest investor must ask themselves whether or not these predictions are truly and consistently repeatable. For most, the answer will be a resounding no.
One of the ways in which an investment manager can add value to a client’s portfolio is by providing the discipline necessary to stick with a long term investment strategy. A good investment manager will have a track record based upon an easily explained, repeatable, consistent process. At those times when the client feels most tempted to search out the hottest new investment trend the manager can remind the client of why a particular investment strategy was implemented in the first place. In today’s low interest rate environment, long term investment discipline is more important than ever.
Brian Perry is an investment strategist at Chandler Asset Management in San Diego.