Making the Case for Diversification Over Market Timing

#Lifestyle Wealth


By Craig Weynand

Often the two most difficult decisions for a financial advisor are: “when should a client exit the stock market,” and “when should he or she get back in?” The answer to either question is never easy, as successful market timing requires two extremely difficult things: buy at the “right time” (on the lows) and sell at the “right time” (at the highs). If you fail to do either consistently, you’ll likely underperform a buy and hold strategy.

Consider the last decade. Though we’ve experienced a 10-year bull run, a variety of metrics have indicated an overvalued stock market for some time. However, if you recommended a client exit his or her stock portfolio at any time in the last 10 years, you likely made a poor decision.  Even if you exited just before a short-lived downdraft, such as Q4 2018, at what point did you advise your client to get back in?  When the market was down 5 percent . . . 10 percent . . . 15 percent? Or are you still on the sidelines, having missed the recent rally?

Realistically, it is impossible to consistently buy on the lows and sell at the highs. That’s why for most investors time in the market almost always beats timing the market, even if that means suffering through a few bear cycles. A number of studies, including the work of Nobel Laureate William Sharpe, conclude that market timers must be correct 70 percent to 85 percent of the time to outperform a passive portfolio of comparable risk.

Most investors tend to buy when the masses are buying (usually at or near the highs) and sell when everyone is selling (usually at or on the lows); indeed, the largest inflows typically occur immediately after above-average performance windows and just prior to poor performance windows.  Likewise, the largest outflows are observed following significant market declines and before subsequent upswings.  Ironically, then, most investors tend to buy high and sell low – the exact opposite of what is required for successful market timing.

Given the difficulty of timing the market, the better approach may be portfolio diversification. Portfolio diversification combines non-correlated asset classes within a single portfolio, creating a mix that has the potential, over time, to reduce overall volatility and increase overall return. Unfortunately, convincing investors of the long-term benefits of maintaining a diversified portfolio, particularly during market downturns, is not easy; however, there exist significant data to support this thesis.

First, research shows that a very small number of days account for the bulk of stock market returns over time.  Miss any one or more of those outliers, and your return may significantly underperform a buy and hold strategy.

  • A study out of the IESE Business School in Barcelona considered more than 160,000 daily returns from 15 international equity markets and concluded that, on average, missing the 10 best days resulted in portfolios that were 50 percent less valuable than a passive investment.
  • Similarly, Professor H. Nejat Seyhun of the University of Michigan found that “between 1926 and 1993, more than 99 percent of the total dollar returns were ‘earned’ during only 5.9 percent of the months;” further, during the 31-year period from 1963 to 1993, only 90 trading days accounted for 95 percent of market gains.

The impact of missing just a handful of such days is also highlighted in Dr. Jacob Lumby’s work, who reviewed the effects of poor market timing on an initial investment of $10,000 in the S&P 500 Index for the 20-year period ending December 31, 2013. He found that (i) given a simple buy and hold strategy, $10,000 would have grown to $58,352 with an annualized return of 9.22 percent, (ii) if you were out of the market during the five best-performing days, your  annualized return would be 7 percent, (iii) if you missed the market’s 20 best-performing days, your annualized return would be just 3.02 percent, and (iv) you would’ve suffered a loss of $1,851 if you missed the 40 best-performing days.

Next, consider the tenets of Modern Portfolio Theory, which suggests that investing in an asset with positive returns and low correlation to other assets improves the overall risk/reward of the entire portfolio. Dr. John H. Lintner of Harvard University further explored this notion. Focused on the addition of a managed futures component to a hypothetical portfolio comprised of 60 percent stocks and 40% bonds, he found that by including a variety of non-correlated assets, such as managed futures, an investor may lower the portfolio’s overall volatility while increasing overall return.

Managed futures have a long history of providing positive returns during periods of equity market turmoil. Since 1980, even a 10 percent allocation to managed futures would have significantly reduced volatility and improved returns as compared to a traditional 60/40 portfolio. Given its non-correlated nature, managed futures offer the potential for positive returns during both up and down markets, including periods of equity market turmoil.

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Successful investors face the challenge of improving portfolio returns while also lowering risk and reducing drawdowns. While no one can predict when the next downturn will occur, financial advisors should consider the benefits of non-correlated assets within a client portfolio, rather than attempt the impossible of market timing.

Craig Weynand is COO of the investment team that sub-advises the Rational/NuWave Enhanced Market Opportunity Fund (NUXIX).

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