I am leery of formulaic approaches to investing and this New York Times article confirmed my prejudices. Conventional wisdown says forget market timing (you are bound to get it wrong and lose out). However, today Mark Hulbert advocates an anti-market-timing strategy: go into cash when markets become volatile.
But that seems as difficult to execute as market timing. How do you define when markets are volatile? A VIX of 30 was once seen as a very high level and would trigger buying as a sign of a near term bottom. Now, a VIX of 30 would be almost routine. It seems that you need to have foresight to know when markets are going to become volatile, and if you had foresight, you could just rely on that. Hulbert does NOT examine exiting the market shortly after it becomes volatile, which is the only realistic way to implement this strategy. Similarly, how can you tell for sure when a volatile period has ended? What measures do you use? After the LTCM crisis, swap spreads were elevated for a full year afterwards. When should you have decided it was safe to get into the pool?
From the New York Times:
Critics of market timing argue that it’s hard, if not impossible, to consistently beat a buy-and-hold approach by jumping back and forth between stocks and cash.
But new research raises the tantalizing possibility that you can do as well as the overall market — with much less risk — by parking your portfolio in the safety of cash during times like these, when market volatility spikes higher.
Market timers have yet to translate this new research into a set of specific rules for trading. But the general idea is to get out of the stock market whenever volatility measures — such as the Chicago Board Options Exchange’s Volatility Index, known as the VIX — rise significantly, and to stay in cash until they come back down.
Of course, such a volatility-avoidance strategy faces long odds. As the critics of market timing often point out, the stock market tends to produce the bulk of its gains in just a few explosive sessions. Miss those days and your portfolio’s returns are likely to disappoint you.
Consider someone who was fully invested in stocks over the last decade — except for the market’s 20 best days, during which he held cash. Despite holding stocks more than 99 percent of the time, this investor would have lost 57 percent through the end of October, as judged by the Dow Jones Wilshire 5000 index, a benchmark that represents the combined value of all domestic stocks. That is 70 percentage points worse than the 13 percent gain he would have achieved had he held stocks mimicking that index for the entire 10 years, including the market’s 20 best days.
Market-timing advocates say it’s unfair to focus only on the consequences of missing the very best days, because the bulk of the market’s declines are also concentrated in just a few sessions. For example, a portfolio fully invested in stocks during all but the 20 worst days of the last decade would have gained 215 percent. That’s more than 200 percentage points better than the return from a straightforward buy-and-hold approach.
THE volatility-avoidance strategy takes the middle ground between these two extremes. It aims to sidestep at least some of the market’s biggest down days and is willing to miss some of the biggest up days, too. Because the best and worst days tend to balance each other out during volatile times, a strategy that moves your portfolio into cash during such periods should produce long-term returns that are close to those of the overall market, while incurring much less risk.
This rough equivalence in returns has prevailed in recent years. Over the last decade, an investor who was out of the stock market during both the 20 best and 20 worst days would have gained 18 percent. That’s just a little better than buying and holding. Yet the volatility of this investor’s monthly returns would have been 9 less than the market’s.
But how can you sidestep even a good portion of the biggest down days?
A growing body of academic research has found that the periods of greatest volatility are in large part predictable. This means that the market sessions with particularly good or bad returns don’t occur randomly, but tend to be clustered together. (Perhaps the researcher most widely credited with documenting this tendency is Robert F. Engle, a finance professor at New York University who was the Nobel laureate in economics in 2003 for his work along these lines.)
The market’s behavior over the last couple of months illustrates of this clustering: By Sept. 18, the VIX, the widely followed volatility index, had climbed to what was then its highest level in five years, greatly increasing the likelihood that the ensuing period would have above-average volatility. Sure enough, 9 of the 20 biggest daily percentage losses of the last decade occurred in the subsequent six weeks, along with 6 of the decade’s 20 biggest daily gains.
But even if they’re successful, volatility-avoidance strategies aren’t for everyone. Long-term investors, for example, presumably don’t care about shorter-term gyrations, and therefore aren’t interested in market-timing approaches whose major benefit is reducing volatility rather than increasing return. Such strategies require close attention to the market, and generate higher costs than simply holding stocks for the long term.
Still, a successful volatility-avoidance strategy would appeal to many investors who have been scared away from the market, worried that they would suffer through more extraordinary fluctuations like those of recent weeks.