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Financial Times - There are only two types of investors

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There is a lot to lose and little to gain from market timing 

I last wrote about the problems of so-called market timing in these pages in 2013 (Market timing: don't try this at home).

With the Covid-19 pandemic dominating the news and recent volatility on world stock markets, you may have heard a lot about market timing again.

Advisers and financial commentators will probably not use that actual term. What they will talk about is whether you should sell some or all of your equity investments because of the economic effects of the coronavirus and the subsequent effect on the markets.

All of this is what is termed “market timing” in the jargon of the investment trade — holding back investment or taking some or all of your money out of the market when you anticipate a fall.

The word “anticipate” indicates the first problem with this approach. Most people whom I encounter take their money out during or after a fall — as they did in March. They are doing the equivalent of driving whilst looking in the rear view mirror (or at best, out of the side window of the car). You need to look out of the windscreen in order to have the best chance of driving safely. The trouble with doing that in terms of the stock market is that the visibility is often so poor, it feels like driving in fog.

Such approaches to investment are almost all futile. Markets are second order systems. What this means is that in order to successfully implement such market timing strategies you not only have to be able to predict events — interest rate rises, wars, oil price shocks, the impact of the coronavirus, the outcome of elections and referendums — you also need to know what the market was expecting and how it will react, and get your timing right. Tricky.

However, there are quite long periods when the market falls and takes a long time to regain previous highs. How shall we judge whether you should try to take advantage of this?

Take the market (in this case the Dow Jones Industrial Average Index — the Dow — which I will use because there is data on this strategy courtesy of YCharts) from 1970-2020. This is a period of 50 years which spans inflationary and deflationary cycles and which has seen several crises and crashes as well as bull markets. It seems like a long and fair sample period.

Imagine that over this 50 year period there were two competing investment strategies. One is to invest an equal amount every trading day throughout the period irrespective of market conditions — so-called pound (or dollar) cost averaging which many investors actually apply by making regular contributions into a pension, Isa or regular savings plan.

The other strategy requires enough foresight for the investor to invest the same amount daily, but to stop investing when the market turns down and save the cash. This money is only invested when the Dow makes a new bottom, hitting its low point in any period of decline (hence why it’s known as an ‘absolute bottom buying strategy’).

In my view, this is a somewhat more realistic example of how you might apply foresight rather than measuring what would happen if you had such certainty about the future you were able to sell everything just before the market turned down and then buy it back at the bottom.

Over the 50 year period, the second strategy would have produced returns 22 per cent higher than the first. It sounds impressive — perhaps a little less so when you break it down to an 0.4 per cent outperformance per year. But think of the time and effort you would have to spend monitoring markets to get those calls just right.

Compare and contrast this with the rise in the market since I last wrote about this subject in March 2013. The Dow is up just over 150 per cent in total, averaging 13.3 per cent per annum. Imagine if you had acted on market fears and taken your money out of equities or stopped investing ahead of that performance. Should you risk foregoing any significant portion of that gain for a maximum upside of 0.4 per cent per year?

In reality, attempts to implement the second strategy will almost certainly cause harm to your net worth as nobody has perfect foresight. In your desire to time the markets, you will stop investing, or worse, sell and take money out when you expect the market to go down, and instead it goes up.

Think back to Brexit and Trump's election. We were told by most commentators that they would not happen, but if they did, the markets would plunge. Not only were they wrong about the events but they were also wrong about the market’s reaction to events. The markets soared.

When it comes to so-called market timing there are only two sorts of people: those who can’t do it, and those who know they can’t do it. It’s safer and more profitable to be in the latter camp.

Terry Smith is the chief executive of Fundsmith LLP; the views expressed are personal.