Testing Market Timing
Posted by: Nicola Macdonald, on March 7, 2016.
Equity markets tend to be cyclical. Positive periods are followed by negative periods, which are then followed by positive periods. Because of this, it is common when markets are falling to ask whether it is possible to time investment decisions to sell at the peaks and buy back at the troughs.
Analyse future and past data
One way to do this might be to analyse forward-looking information such as economic and corporate data and make predictions about the direction of the markets. But it is hard to make predictions, especially about the future.
Another approach might be to look back at data from previous cycles and identify patterns that could be repeated going forward. Researchers at Dimensional Fund Advisors did exactly this, running almost 800 tests on data from 15 world equity markets to identify signals that might point to a change of market cycle and simulating the trading activity that might improve investment returns.
Most of the 800 tests failed and resulted in worse performance than would have been achieved by just going with the flow of the market. But some of the tests worked and produced positive performance results.
You might think this is good news for investors—that they can replicate the trading patterns suggested by the positive tests. Unfortunately, the number of positive results was no greater than one might expect with such a large number of tests.
As the researchers explain, the odds of one person coin flipping 10 heads in a row are small. But if you asked 100 people to try, you would expect around five of them to be successful. The same proportion of the 800 market tests were positive and the research was unable to determine if any of them were more than just a sequence of lucky coin tosses.
James Davis explains this clearly in this short video ‘Can you predict a good time to buy and sell stocks?’
The conclusion of the research is that, on average, investors are better off sticking to their long-term investment goals and riding out short-term market volatility, rather than trying to time their trading to coincide with the peaks and troughs of the market.
This is also the approach we advocate at volatile times such as these. To discuss your investment requirements, please call us on 01825 76 33 66 or complete the contact form.