How and when should you buy in and sell out of the stock market? My natural response to this age old question is to suggest that one should buy when it is low and sell when high. A less frivolous answer however in this instance is required.
"If one of these is missing, it does not matter whether markets are predictable"
The question should first be boiled down to two constituent parts. First, are stock markets predictable or unpredictable? If they are unpredictable, aka ‘efficient’, then your exposure to equities should be based solely on your investment time horizon and your tolerance of short-term volatility. With a long investment time horizon – one associated perhaps with retirement savings and at least 10 years of life expectancy – and a sensible tolerance for volatility, you should have a large proportion of your portfolio in equities. Furthermore, you should decrease it – gradually and systematically – once your time horizon hits a couple of decades or so.
Second, if a stock market is predictable, are you, personally, in a position to take advantage of the predictability, to buy in and sell out during your investment journey – as well as at each end – in order to enhance your returns? Note that if stock markets are unpredictable this second part of the question is moot.
I will address the first question in a moment, but whether you can take advantage of any predictabilities depends on whether you have the tools, skills, and time to seek them out. If one of these is missing, it does not matter whether markets are predictable.
Hedge fund manager Jim Simons is an example of someone with all three of the above requirements. He takes advantage of short-term predictabilities in markets and his hedge fund, Renaissance Medallion fund, has averaged returns of around 30% pa over the last 20 or so years. Simons, however, is a maths genius. He also has the world’s largest privately owned supercomputer which he and his team of geniuses uses to analyse millions of price movements every second.
Back to part one of the question: are stock markets predictable? Since, as Simons has shown, short-term predictabilities are out of reach of us mortals, the question really is whether longer term predictabilities exist.
One way to assess whether there are predictabilities in markets is to apply a variance test. If a stock market follows a random walk, the volatility – variance – of returns will rise in proportion to the time over which returns are measured.
For example, for a market that follows a random walk, the variance of two-year returns should be twice the variance of one-year returns, which in turn should be twice the variance of six-month returns, etc. If this is not the case, and variance is either much higher or lower than it should be, the stock market in question has exhibited predictability, predictability that can be used to enhance investment returns.
To put this into English, a stock market that falls sharply tends to recover. This predictability – pattern – is called mean reversion, and it manifests in many markets around the world. Buying after sharp falls – which naturally happen every few years – and selling a year or so later, can often add a few percentage points of performance.
Indeed, such action is exactly what is recommended in a paper by financial planner Bill Bengen titled Determining Withdrawal Rates Using Historic Data you are unlucky enough to experience a major drawdown in equities as you enter retirement, the best course of action is to increase, temporarily, your exposure to equities.
A business cycle approach to asset allocation – which in many respects is about when to buy in and sell out of the stock market – is based on the same pattern of mean reversion.
Equities tend to rise far above trend towards the end of a business cycle, fall sharply as a recession is anticipated, then rise again in the next cycle.
Unless of course you lack either the tools, skills or time to commit to the exercise, in which case the advice is to not try to time markets but to follow a passive approach. In other words, not to ‘buy low, sell high’ but to ‘buy young, sell old’.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
Thanks Peter.