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The Problem with Market Timing Research

I recently took a continuing education class about retirement planning. The instructor was super enthusiastic about a recent piece of research that showed that, based on historical data, retirees’ ability to safely spend from their portfolios would be improved if they followed a set of rules in which they dramatically adjust their asset allocation each year based on current interest rates and price-to-earnings ratios.

Personally, while I find such research interesting, I don’t think I’d be able to trust it if it were my own money on the line.

My qualms can be best explained by an analogy I heard several years ago (though I don’t remember where).

Imagine that we want to test whether eating various types of mushrooms improves health outcomes among people with pancreatic cancer. So we find 50 people with pancreatic cancer who are willing to participate in a study, and we find 50 different species of mushrooms. Each person in the study gets one type of mushroom, and they eat that mushroom everyday for lunch. Person 1 eats Mushroom A everyday, Person 2 eats Mushroom B everyday, and so on.

As it turns out, Person 17’s cancer quickly goes into remission, while he’s eating Mushroom Q every single day.

What does that tell us? Not a lot, really. Mushroom Q might be useful as a treatment. Or perhaps Person 17 was just a lucky individual, and it has nothing to do with mushrooms.

Fortunately for the sake of our research, mushrooms (at least the ones we’re testing) are harmless and not especially expensive. In addition, there are lots of people with pancreatic cancer. So we could do a study in which many people with pancreatic cancer are given Mushroom Q (while others are given a placebo), and we see what happens. In just a handful of years, we’d have a decent idea of whether this mushroom really has any effect or not.

Unfortunately, for two reasons, this type of research isn’t really possible for market timing strategies.

Problem #1

With investing, somebody can look at historical data and come up with a strategy that would have worked wonderfully in the past. This is like the first part of our mushroom research in which we test a bunch of different mushrooms. But we can’t go out and do a large number of simultaneous tests of the new strategy. For example, if we want to test how a certain market timing strategy affects likelihood of portfolio depletion over a 30-year retirement, we have to wait 30 years to get any new independent data points.

And by then:

  1. Your own personal opportunity to benefit from such rule has likely expired, and
  2. There’s a decent chance that markets have changed in some way that invalidates the conclusion anyway. (When successful market-beating strategies become commonly known, they usually stop working as the market adjusts.)

Problem #2

Part of what makes our hypothetical mushroom trials feasible is that all of the people involved can still get whatever medical care is currently considered to be the best for fighting their cancer (e.g., radiation, chemo, surgery, etc.). That is, the patients don’t have to bet their lives on mushrooms being more effective than chemo/radiation/surgery.

With investing, current conventional wisdom says that using a “strategic asset allocation” strategy is the best approach (i.e., an allocation that varies with your life circumstances but not with market indicators). You cannot simultaneously use that type of strategy and a “tactical asset allocation” strategy in which you vary your allocation based on your chosen indicator(s). It’s one or the other.

In other words, to the extent that you want to try out the new approach, you have to abandon the conventional wisdom approach. There’s no “chemo, plus eat some mushrooms” option here.

Investing Based on Market Valuation

I recently came across an excellent article by Todd Tresidder discussing the many imperfections of the 4% withdrawal “rule” for retirement planning. In the article, one of the suggestions Todd makes is to incorporate market valuation levels (as measured by PE10) into retirement planning decisions.

Because using market valuation (most commonly measured as PE10) as an input in investing decisions is a topic that comes up fairly often, I thought it might be helpful to share my thoughts here on the blog.

What is PE10?

PE10 is calculated as the current market price of the S&P 500, divided by the average of the last ten years of inflation-adjusted earnings for the S&P 500.

Like regular P/E ratios, the idea is that it can be used as an indicator of whether the current price (of the S&P 500, in this case) is high or low relative to earnings. The purpose of using ten years of earnings rather than just one year is to eliminate the impact of meaningless short-term fluctuations in earnings.

Uses of PE10: Asset Allocation and Withdrawal Rates

The most common suggested use of PE10 is to use it to make asset allocation decisions. For example, researcher Wade Pfau wrote a fascinating paper showing that from 1871-2009, a market timing strategy using PE10 (i.e., moving to stocks when the market is at a low PE10 and moving to Treasury bonds when the market is at a high PE10) would have significantly outperformed a simple portfolio with a fixed 50/50 stock/bond allocation.

A second, related use of PE10 is to use it as an input when deciding how much you can safely spend from your portfolio per year in retirement. Again, Wade’s research on the topic is excellent. He shows that, historically, the higher the market’s value (relative to earnings) when you retire, the less you can safely spend from your portfolio per year.

Why I Don’t Use PE10

Despite the data showing the historical usefulness of PE10, I’m not comfortable using it for my own portfolio decisions.

As a general rule, the market does not like to be predictable. For the most part, once market inefficiencies (i.e., patterns that can be used to reliably outperform the market) become well known and easy to exploit, they tend to disappear.

It seems entirely likely to me that PE10’s predictive value is a market inefficiency like any other and that the primary reason it has existed for so long is that there was no way to exploit it. That is:

  1. Prior to computers, it would have been an enormous task to even calculate PE10, and
  2. Prior to the existence of no-load index funds (i.e., prior to 1977), there was no cheap, easy way to invest in the market as a whole. Moving in and out of stocks to capitalize on PE10’s predictive value would have meant buying or selling a large portfolio of individual stocks and paying transaction costs that are far higher than they are today. (Higher commissions, higher bid/ask spreads, and usually higher taxes.)

So rather than a data set of 140 years, we’re left with just 34 years (1977-2010). For an indicator that is only supposed to have useful predictive value over periods of 10+ years, 34 years isn’t a heck of a lot to go on.

Is Using PE10 a Terrible Idea?

Despite my personal lack of confidence in PE10 as a useful predictor, I think I’d place PE10-based decisions in the group of investment approaches that are at least reasonable — far better than, say, day-trading individual stocks.

For instance, if PE10 was at a historical high at a time when TIPS yields were also very high, I wouldn’t fault somebody for moving more of their portfolio to TIPS. Similarly, I think it would be reasonable to use a lower withdrawal rate if you retire at a time with unusually low TIPS yields and an unusually high PE10.

On the other hand, I’d be extremely reluctant to suggest either moving more of a portfolio to stocks or using a higher withdrawal rate from a retirement portfolio just because PE10 is low by historical standards.

Vanguard Wellington: Is it a Good Fund?

As a follow-up to Monday’s post about selecting funds only after choosing an asset allocation, I received this question:

I know you prefer index funds, but what about a low-cost actively managed fund with a great track record? If it fits my asset allocation, should I have it in my portfolio?

Specifically, I’m thinking of Vanguard’s Wellington fund, which appears to consistently outperform Vanguard’s Balanced Index Fund, which has a similar asset allocation.

Using Appropriate Benchmarks

While Wellington does have a similar allocation to Vanguard’s Balanced Index Fund, they’re not precisely the same. Wellington actually should have somewhat higher (before-cost) returns than Vanguard’s Balanced Index Fund because it takes on somewhat higher risks:

  • The overall portfolio has a slightly higher stock allocation (66% rather than 60%),
  • The stock portion of the portfolio is tilted toward value stocks, and
  • The bond portion of the portfolio has significantly more credit risk: Wellington has just 6% of its bonds in Treasury/U.S. agency bonds, whereas the balanced fund has 43% in Treasury/U.S. agency bonds.

To see whether Wellington’s management has added value, it would be best to compare the fund’s results to those of an indexed portfolio with a closer-matching composition. Something like this, perhaps:

  • 54% Vanguard Value Index Fund,
  • 12% Vanguard Total International Stock Index Fund,
  • 28% Vanguard Intermediate-Term Investment Grade Fund,
  • 6% of your money market fund/account of choice

How Did Wellington Do?

How does Wellington hold up when compared to such a portfolio?

I don’t know. Because I didn’t check.

Frankly, I’m not all that curious. Checking an actively managed fund’s performance against a relevant benchmark tells you how well the fund did, but it doesn’t tell you much about how well the fund is going to do, which, of course, is what we care about.

The bottom line is that there’s just no way to know whether an actively managed fund’s returns are the result of skill or luck.

So is Wellington a Bad Choice?

I don’t use Wellington in my portfolio. But I wouldn’t say it’s a bad choice by any means. I know several very well-informed investors who use it in their own portfolios. (And I’ve read that John Bogle holds it in his own portfolio.)

Wellington’s expense ratio is just 0.22%, assuming you qualify for Admiral shares. For an actively managed fund, that’s extremely cheap–just ~0.10% higher than what you’d pay for most Vanguard index funds.

If you want to make a bet on active management, you’d be hard-pressed to find a lower-cost bet than Wellington.

Just be careful not to assume that Wellington’s past performance figures (whether absolute returns, or returns as compared to relevant benchmarks) tell you very much about how the fund is going to perform in the future.

Stocks or Mutual Funds: Which Should I Buy?

Ask a beginner-level investor what investing is about, and you’re likely to get an answer to the effect of, “Buying stocks of companies that are likely to grow quickly.”

That’s understandable, since it’s the lesson one might gather from much of the mainstream financial media. But that description is way off base for two reasons:

  1. It’s important to own investments other than stocks (most importantly: bonds), and
  2. There are very few circumstances in which it makes sense for an individual investor to own individual stocks rather than mutual funds.

The reason it’s (usually) such a bad idea to own individual stocks is that it results in more risk without (in most cases) the expectation of higher returns.

Why Are Individual Stocks Riskier?

This is the easy question. The more of your portfolio you have invested in any one company, the more risk you’re exposed to. Nothing hard to understand about that.

By investing in a broadly-diversified mutual fund (for instance, Vanguard’s Total Stock Market Index Fund, which includes over 3,000 different companies), your portfolio will be exposed to far less company-specific risk than if you own just a handful of individual stocks.

Why Is it Hard to Pick Above-Average Stocks?

This is the question many investors struggle with. Many people are unaware of the fact that there’s more to picking winning stocks than simply finding companies that will experience above-average growth.

At any given moment, a company’s stock price already includes the market’s best estimate of the company’s future growth. So a stock’s performance isn’t a function of how quickly the company grows. It’s a function of how the company’s growth compares to its expected level of growth.

In other words, picking an above-average stock does not mean finding a company that’s going to grow quickly. It means finding a company that will grow more quickly than the market expects it to.

And that’s no small task. The market is made up of millions of individual investors as well as a small army of highly-intelligent, specifically-trained professionals whose sole job is to estimate such growth figures. It’s silly for most individual investors to think that we can reliably outsmart such a massive collection of data and intelligence.

When Might It Make Sense to Own Individual Stocks?

Despite all of the above, there are a few scenarios in which an investor would want to own individual stocks. For example:

  • Your company’s retirement plan gives you shares of company stock, and you’re not yet allowed to sell it (or you’re holding it to take advantage of the Net Unrealized Appreciation rules), or
  • You’re looking to do something other than maximize your returns for a given level of risk. For example, you derive an entertainment benefit from picking stocks or a self-actualization benefit from buying the stocks of companies that do things you morally approve of.

But for most investors, there’s no reason to own any individual stocks whatsoever. Doing so just increases the risk in your portfolio without increasing your expected return.

Successful Trading Techniques

I recently received an email from a reader asking for my advice on trading. He was looking for “a successful trading technique with a good shot at beating the market.”

My reply–and this won’t surprise regular readers–was to ask what reason he has for thinking that an individual investor can reliably outwit the professionals.

His answer: I need a 12% return in order to retire on time. So normal market returns probably won’t cut it.

The Market Doesn’t Care.

Unfortunately, the market doesn’t care that you need a reliable 12% annual return in order to make your retirement plans work. Your need for a given return doesn’t increase your probability of getting it.

To use an analogy: “Going 60 mph won’t get me to work in time” is not a good reason to drive 120 mph. Similarly, “normal market returns aren’t good enough” isn’t a sufficient reason to try to earn above-market returns.

If you have no reason to think that you have a meaningful advantage over the professionals–and I would argue that most investors do not–then the only reasonable answer is to adjust your plans. Figure out a way to make your life work with market returns, whether that means retiring later, working part-time, or cutting your expenses.

Is Technical Analysis Profitable?

Technical analysis is a method of attempting to predict future movements in stock prices based upon data about past movements in prices. For example, when you see an article or book discussing the significance of patterns found in stock price charts, the writer is using technical analysis.

As I’ve mentioned before, when considering an investment strategy, the three questions I ask are:

  1. How well has it performed in the past?
  2. Why has it worked?
  3. Why should it continue to work (even if everybody finds out about it)?

Three gentlemen recently performed an extremely thorough study in an attempt to answer question #1 regarding technical analysis.

What they Tested

They tested 5,806 technical trading rules and applied them each to 49 different countries–the 49 countries (some developed markets, some emerging markets) that make up the Morgan Stanley Capital Index (MSCI).

The trading strategies they tested were broadly categorized as:

  • Filter rules,
  • Moving average rules,
  • Support and resistance rules, and
  • Channel break-outs.

The Conclusion?

“We find no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation, once we take account of data snooping bias. There is some evidence that technical analysis works better in emerging markets, which is consistent with the literature that documents that these markets are less efficient, but this is not a strong result.”

Wow. That’s not terribly promising. But what about that bit regarding emerging markets? Is it worth exploring further? Here’s what the authors of the study have to say:

“The closest any market gets is Colombia, whose best performing rule only just fails to be statistically significant after data snooping bias adjustment.”

So if you’re looking to invest in Columbia, technical analysis is almost likely to be profitable. Everywhere else, things don’t look so rosy. Who could pass up such an opportunity for riches? 🙂

One Additional Concern

In regards to my three tests above, technical analysis doesn’t seem to make it past the first one. But even if it did, I don’t see how it could make it past test #3. I don’t see any credible reason why profitable technical analysis methods should continue to be profitable once word gets out about them.

Our financial markets may not be perfectly efficient, but surely by the time I (or you, or any other individual investor) hear about reliably profitable technical analysis strategies, the big market players have already found out about them as well, thereby eliminating any hope we may have previously had of profiting from them.

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