Myth: 'Buying the Dip', 'Forecasting' or 'Timing the Markets' Works.
Previously I posted about a question that was asked of me ‘What research do you use not that you’re no longer at TD?’. Throughout this week I’m going to continue answering the question and talk about the types of research I follow – and how it helps guide the investment side of how I work with clients.
Too often I hear stories about promises made to investors that advisors or portfolio managers have a way to time the market or have some sort of insight into the future that will allow them to move in and out of stocks, bonds, or cash and thus lead to higher risk adjusted returns.
The narrative will go something like this ‘we are entering into the _______ stage of the economy [a forecast], which means we are going to adjust our strategy [market timing] into something different than now [like more or less of cash, fixed income, or equities, or a subset of this – like more or less international or emerging markets fixed income or equities].’
People make decisions based on stories, it’s how we humans have communicated for millennia. We teach our children about hard work and selflessness through stories like ‘The Little Engine That Could’. We would much rather tell ourselves that we are invested in a strategy that has someone working hard behind the scenes to ‘earn their keep’ or the fees they’re charging.
This is the premise behind ‘Tactical Asset Allocation’ – the story being told is that portfolio managers or advisors are able to proactively and repeatedly implement shifts between stocks, bonds and cash to gain an edge on the markets and deliver higher risk adjusted returns. This is what is called ‘Market Timing’ – the thought that with research and skill, an advisor or portfolio manager can add value by shifting from one investment type to another.
‘Strategic Asset Allocation’ on the other hand is the null hypothesis – it follows a pre-set allocation of investment weights that remains static, and when done correctly is aligned with the needs of a financial plan within the context of an investors risk profile. Essentially – there’s no reactions to forecasts, no market timing, or ‘buy the dip’ strategies – the investor simply has to stay the course.
Tactical sounds better doesn’t it? Especially when positioned by someone positioned as an expert in the field.
“Our chief economist is recommending an overweight of US equities” sounds a lot better than “No changes recommended, again” to anyone who is trying to make smart decisions with their money.
While this sounds great on paper – for advisors and managers to use their wits to predict the market directions or geographic shifts – the results are again disappointing.
We can think about it this way, as summed up by Vanguard:
“…for any tactical move to be successful, managers need to be right not just once, but at least five times:
- Identify a reliable indicator of short-term future market returns.
2. Time the exit from an asset class or the market, down to the precise day.
3. Time re-entry to an asset class or the market, down to the precise day.
4. Decide on the size of the allocation and how to fund the trade.
5. Execute the trade at a cost (reflecting transaction costs, spreads, and taxes) less than the expected benefit.
Even if a portfolio manager can get these steps right most of the time, the value added over the long term is marginal…an investor would have to be correct 75% of the time or better – a very tall order! – to get a return only slightly higher than that of the traditional baseline portfolio of 60% U.S. equities and 40% U.S. fixed income.”
As the chart below shows, the results of this strategy have failed to live up to the promises made, showing that the experts have consistently underperformed the basic, 'no changes needed' approach.
Simply Put: If an advisor is telling you that they have a strategy that can dynamically move in and out of the market in a way that produces superior risk adjusted returns – ask for evidence. It simply does not exist.
The story sounds great though.
Sources for this post:https://institutional.vanguard.com/insights-and-research/perspective/tactical-vs-strategic-asset-allocation.html
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