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11.21.03
 By Paul Merriman
In politics, Republicans typically have an awful time saying nice things about Democrats, and vice versa. And when you’re rooting for a basketball team, the referees always seem to favor the other side. When it comes to investing, many buy-and-hold investors think market timers are grossly misguided, and at the same time many timers just can’t understand why buy-and-holders leave their portfolios exposed to potentially huge market risks.
I’m not going to settle that debate this month, any more than I could prove that chocolate or peppermint fudge is a better or worse flavor of ice cream than vanilla. But as the year winds down, this is a good time for all investors to re-examine their approach to investing. Some people are confirmed buy-and-holders. Others are market timers. Many use timing to manage some of their money and take a buy-and-hold approach with the rest. | A huge number of investors think they are buy-and-holders, but in fact they use a peculiar form of market timing that we have described before, the ICSIA or "I can’t stand it anymore" timing system. Though this is probably the most widely used timing system in the world, we don’t recommend it. It relies on emotional reactions to market fluctuations. After a long period of market gains, this system induces many of its followers to finally jump into the market, usually against their better judgment, when they can no longer stand to sit on the sidelines watching other people making what looks like "easy money." When the market’s in decline, this irrational system prompts its followers to remain invested, even as they continue to lose money, until they cannot stand the losses any more – and then to bail out when prices are very depressed.
It’s interesting that almost everyone who practices this system would agree with the notion that an investor should "buy low, sell high." Yet in effect the ICSIA system usually leads them to do the exact opposite. I’ll assume that you would never use that timing model. But I’ll bet you know people who do!
This article is for investors who choose more rational strategies and are committed to do their best to stick to them. As we will see, that is easier said than done. But it can be done, and what follows may help you significantly increase your chance of success.
WHY THIS IS COMING FROM US
We built our reputation as market timers, and we understand it as well as anybody in the business. But we also offer buy-and-hold approaches and advice, and that gives us a unique perspective and the ability to take an unbiased view that most advisors cannot. Very few advisors can offer both types of strategies, just as few political analysts or sports commentators can be truly objective. The reason: sports, politics and investing all involve the tug of conflicting emotions. And conflicting emotions just can’t occupy the same brain at the same time very well. It’s hard to be happy and sad simultaneously. It’s pretty hard to cheer when the market goes down (as you would if you were a short-seller of securities) and also cheer when you see it go up (which makes most investors happy).
Think of the pickle I’m in. Every day the stock market is open, our clients are either making or losing money. Quite often, some clients are making money and others are losing it, all on the same day. The best days (Line 1 in the following table) occur when the market is up and all our clients make money because we are fully invested. On other days (Line 2 in the table), the market is up and our buy-and-hold clients get the full benefit from the rise while our timing clients are partially on the sidelines and missing part of that opportunity to make money. Such days are tolerable for us, because those timing clients are participating in at least part of the advance.
But there are other days (Line 3 in the table below) when the market is up and all our timing models are on sell signals. That’s when it gets complicated. Our buy-and-hold clients make money. Many of our timing clients are in a neutral position, getting money-market returns. But other timing clients, those who use simulated short positions (such as the Rydex Ursa Fund) lose money. Those are tough days for us. It’s not any simpler on days when the market is down.
I’ve tried to sort it out in the table below. "Our signals" are those generated by our four U.S. equity timing models. The "aggressive strategies" column applies to timers who use real or simulated short sales when all four models are in a sell mode and who use real or simulated margin when three or more models are in a buy mode.
This discussion focuses on individual days. But the same patterns can be just as true when you look at a week, a month, a quarter or a year. It just gets much more complicated for timing clients because of the interim market swings and changes of buy and sell signals within a week, month, quarter or a year.
You can see why, if you ask me whether I want the market to go up or down, my response will depend on what strategy is being used to manage your portfolio. What I really want is not for the market to do some particular thing, but for investors to have the strategies that are right for them. And I want them to have the tools to stick with those strategies without getting thrown for a loop by their emotions. That’s what FundAdvice.com is about. And by the time you finish this article you’ll have the information you need in order to know whether you will be more comfortable as a buy-and-holder or as a timer. You’ll know the advantages and disadvantages of each approach and you’ll know what emotional challenges each presents. And you’ll have some important tips on how to be successful with whichever investment approach you take.
Before we take a detailed look at each approach, let’s make some general comments. Some people think timing is an aggressive, risky way to approach the market, darting in and out, always looking over your shoulder. They think buy-and-hold investing is relatively safe. Other people see the opposite: timing is safer because it lets investors actively try to preserve their capital in downturns, while buy-and-hold investors take more risk by leaving themselves exposed.
In fact, either approach can be aggressive and either can be conservative. When you’re buying and holding, you become more conservative or more aggressive by adjusting your balance of fixed-income and equities investments. The most aggressive buy-and-hold approach is 100 percent in equities; the most conservative is 100 percent in fixed-income. In market timing, your fixed-income/equities balance also makes your portfolio more conservative or more aggressive. In addition, you can be more aggressive by using your timing models for leveraged investing or short sales.
Of the investors I talk to, those who participated in the market from 1965 to 1982 seem to have a bias toward timing. Investors who know only the 1990s may find this hard to believe, but from 1965 to 1982, after inflation, the U.S. stock market as a whole just broke even. Almost everybody who entered as a buy-and-holder in the late 1960s took a bath by the mid-70s, and it took them until the early 80s to fully recover.
I entered the investment business as a broker in 1966, and over the next decade, I saw many people lose most of the money they had invested in the glamour stocks of the day. Just about any stock with a name tied to the electronics industry was perceived as a potential gold mine. (Could there be a parallel with Internet stocks today?) A lot of extremely aggressive mutual funds, known at the time as "go-go funds," loaded up on such stocks, leaving their investors with big losses.
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About the Author:
Paul Merriman is founder and president of Merriman Capital Management in Seattle and editor and publisher of http://www.FundAdvice.com. He is the author of two books on investing and writes a weekly column on mutual funds for CBSMarketwatch.com.
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