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Using Timing to Control Risk
by Dave Van Knapp,
author of SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
December, 2007
Every Sensible Stock Investor tries to manage his or her risks. There are
various ways to do this. One of them is timing.
Most mainstream investment literature and academic studies deride timing as
impossible and foolish. "You cannot time the market, and you shouldn't try,"
they say. This view is based on the truism that "perfect" market timing is
impossible.
But it ignores the possibility that approximate, or directionally correct, timing
can help you make better investment decisions.
Rather than get stuck in dogma, let's start with an open mind and see what
makes sense. First, remember the two risks you are trying to manage when you
invest: (1) The possible loss of money; and (2) the loss of purchasing power
you will suffer if your investments do not keep up with inflation.
The most common way to reduce risk--approved by Wall Street and
academia--is to diversify your investments. That means putting your money into
non-correlated assets that are unlikely to move up and down together.
Diversification makes sense intuitively, and it works. It smooths out fluctuations
in your overall portfolio.
Unfortunately, it can also hold you back. The main diversification path for the
average investor is bonds (or bond funds). Having a portion of your money in
bonds reduces portfolio fluctuations, because (1) bond cycles are typically
different from stocks, and (2) bond fluctuations are usually less severe than
stocks. So bonds smooth out the ups and downs of your portfolio.
However, the return from bonds has historically not kept up with inflation. So
the bonds in your portfolio do not protect you from risk #2 above--in fact, they
increase the probability that your portfolio will not keep up with inflation.
On the other hand, historically stocks have gained an average of 10% to 11%
per year. That covers risk #2, because 10% to 11% exceeds the 3% (or so)
inflation rate of the past couple of decades. But stocks have done that with
much greater volatility than bonds, including some losing streaks of more than
2-3 years duration, and other "sideways" periods even longer than that. Those
10% to 11% returns have been "lumpy." That increases risk #1, the risk of
actually losing money, especially over short or medium time frames.
That's where timing can help. If timing were perfectible, you would want to be
out of the market when it is going down and in when it is going up. Nobody has
a crystal ball showing where the market is about to go, so perfect market timing
is impossible. But being, approximately correct (that is, directionally correct and
just a little bit late or a little bit early) most of the time is not impossible. The
overwhelming importance of managing risk #1--that is, not losing money--
suggests that the Sensible Stock Investor may want to try timing to reduce his or
her overall risk.
It has been stated that the majority of investors say they believe in buying and
holding. (Their behavior may indicate otherwise, but that is what they say.) If
holding all your stocks "forever" describes what you are comfortable with, then
timing is not appropriate for you. Stick with diversification as your
risk-management strategy.
But if you are not willing to sit passively and watch your capital erode during a
prolonged market downturn, consider timing as part of your loss-control toolkit.
Note that you can use both diversification and timing. Timing is just one tactic
within an overall philosophy of what I call "buy-to-hold." That means that your
intent when you buy a stock is to hold it "forever," but that you will sell it when,
for some reason, it individually becomes a loser, or when a prolonged bear
market is taking your stock down with it.
Properly used, timing is not based on emotions nor on short-term volatility
swings. Rather, it is based on sound factors that have demonstrated that they
are somewhat predictive of medium-term market trends. The indicators are
calculated mechanically, and the outcome is used to influence buy, hold, and
sell decisions. So your timing strategy is worked out beforehand, then executed
in real time.
Both buy-and-hold investors and timers get in trouble when they don't really
follow their strategies. In each case, they substitute emotion for logic, feelings
for strategies. They depart from their strategies, often with unpleasant
consequences.
Sensible Stock Investors, in contrast, develop sound, logical strategies first, and
then execute them to the best of their abilities. That does not mean that you
stick slavishly to the first approach you ever develop. Indeed, annual
re-examination of strategies is one of the keys to successful investing. But on a
day-to-day or week-to-week basis, you should be executing your strategies, not
jumping around based on the emotion du jour or the latest hot tip.
The most sensible way to "do" market timing, in my view, is to adopt a
fact-based discipline that does not require emotional judgments, forecasts, or
guesswork. I have developed such a system, called simply The Timing Outlook.
It is explained in my book, SENSIBLE STOCK INVESTING: How to Pick,
Value, and Manage Stocks.
The Timing Outlook is based on four factors which have been shown, over the
years, to impact market performance:
--The economy
--Interest rates
--Market valuation
--Market trends
There is not space here to go into the calculation of The Timing Outlook. But
the "score" of the Outlook's indicators is available, for free, to readers of my
free newsletter. Use the link in the right-hand column on this page. Once at the
newsletter, you can subscribe to it, if you wish. It will arrive free in your
in-basket whenever I post a new article or Timing Outlook.
by Dave Van Knapp,
author of SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
December, 2007
Every Sensible Stock Investor tries to manage his or her risks. There are
various ways to do this. One of them is timing.
Most mainstream investment literature and academic studies deride timing as
impossible and foolish. "You cannot time the market, and you shouldn't try,"
they say. This view is based on the truism that "perfect" market timing is
impossible.
But it ignores the possibility that approximate, or directionally correct, timing
can help you make better investment decisions.
Rather than get stuck in dogma, let's start with an open mind and see what
makes sense. First, remember the two risks you are trying to manage when you
invest: (1) The possible loss of money; and (2) the loss of purchasing power
you will suffer if your investments do not keep up with inflation.
The most common way to reduce risk--approved by Wall Street and
academia--is to diversify your investments. That means putting your money into
non-correlated assets that are unlikely to move up and down together.
Diversification makes sense intuitively, and it works. It smooths out fluctuations
in your overall portfolio.
Unfortunately, it can also hold you back. The main diversification path for the
average investor is bonds (or bond funds). Having a portion of your money in
bonds reduces portfolio fluctuations, because (1) bond cycles are typically
different from stocks, and (2) bond fluctuations are usually less severe than
stocks. So bonds smooth out the ups and downs of your portfolio.
However, the return from bonds has historically not kept up with inflation. So
the bonds in your portfolio do not protect you from risk #2 above--in fact, they
increase the probability that your portfolio will not keep up with inflation.
On the other hand, historically stocks have gained an average of 10% to 11%
per year. That covers risk #2, because 10% to 11% exceeds the 3% (or so)
inflation rate of the past couple of decades. But stocks have done that with
much greater volatility than bonds, including some losing streaks of more than
2-3 years duration, and other "sideways" periods even longer than that. Those
10% to 11% returns have been "lumpy." That increases risk #1, the risk of
actually losing money, especially over short or medium time frames.
That's where timing can help. If timing were perfectible, you would want to be
out of the market when it is going down and in when it is going up. Nobody has
a crystal ball showing where the market is about to go, so perfect market timing
is impossible. But being, approximately correct (that is, directionally correct and
just a little bit late or a little bit early) most of the time is not impossible. The
overwhelming importance of managing risk #1--that is, not losing money--
suggests that the Sensible Stock Investor may want to try timing to reduce his or
her overall risk.
It has been stated that the majority of investors say they believe in buying and
holding. (Their behavior may indicate otherwise, but that is what they say.) If
holding all your stocks "forever" describes what you are comfortable with, then
timing is not appropriate for you. Stick with diversification as your
risk-management strategy.
But if you are not willing to sit passively and watch your capital erode during a
prolonged market downturn, consider timing as part of your loss-control toolkit.
Note that you can use both diversification and timing. Timing is just one tactic
within an overall philosophy of what I call "buy-to-hold." That means that your
intent when you buy a stock is to hold it "forever," but that you will sell it when,
for some reason, it individually becomes a loser, or when a prolonged bear
market is taking your stock down with it.
Properly used, timing is not based on emotions nor on short-term volatility
swings. Rather, it is based on sound factors that have demonstrated that they
are somewhat predictive of medium-term market trends. The indicators are
calculated mechanically, and the outcome is used to influence buy, hold, and
sell decisions. So your timing strategy is worked out beforehand, then executed
in real time.
Both buy-and-hold investors and timers get in trouble when they don't really
follow their strategies. In each case, they substitute emotion for logic, feelings
for strategies. They depart from their strategies, often with unpleasant
consequences.
Sensible Stock Investors, in contrast, develop sound, logical strategies first, and
then execute them to the best of their abilities. That does not mean that you
stick slavishly to the first approach you ever develop. Indeed, annual
re-examination of strategies is one of the keys to successful investing. But on a
day-to-day or week-to-week basis, you should be executing your strategies, not
jumping around based on the emotion du jour or the latest hot tip.
The most sensible way to "do" market timing, in my view, is to adopt a
fact-based discipline that does not require emotional judgments, forecasts, or
guesswork. I have developed such a system, called simply The Timing Outlook.
It is explained in my book, SENSIBLE STOCK INVESTING: How to Pick,
Value, and Manage Stocks.
The Timing Outlook is based on four factors which have been shown, over the
years, to impact market performance:
--The economy
--Interest rates
--Market valuation
--Market trends
There is not space here to go into the calculation of The Timing Outlook. But
the "score" of the Outlook's indicators is available, for free, to readers of my
free newsletter. Use the link in the right-hand column on this page. Once at the
newsletter, you can subscribe to it, if you wish. It will arrive free in your
in-basket whenever I post a new article or Timing Outlook.
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