Time For A Little Market Timing?
As I write this, the Dow Jones Industrial Average has just given up its gains for the year; foreign stocks and especially emerging-market stocks have taken a large hit; even commodities and gold have tanked. It appears there is no place to run and hide. more

BFA Notes
Here's what's been happening at BFA. more

Established in 1985, the Saudi “bourse” is young. Yet by 2005, it was the biggest emerging market by capitalization, exceeding major markets like Korea, Russia, and China. The Saudi government encouraged its citizens to participate in the market, wanting to help them benefit from the country’s prosperity. The citizens obliged, rushing in to purchase a series of IPO’s and even borrowing money in order to make larger investments. As one newspaper reported,

It was [ ] not uncommon for an investor swept up in the market euphoria to sell all his assets, including his home, car and to borrow from his wife and friends, and then obtain a loan for the same amount from his bank with the collateral as security. (AME Info FZ, 5/20/2006, “Saudi Stock Market Crash A Cause for Concern”).

Market returns of over 90% in 2005 flamed the fires further. By early 2006 the Saudi Kingdom even had a problem with teachers, not students, playing hooky in order to trade. (Gulfnews.com, 1/27/06, “Teachers Play Truant to Play on Bourse.”)

Naturally, there were many reasons given for why a severe market crash was unlikely. Some thought that the Kingdom’s oil-derived prosperity itself would prevent a crash. Others noted that large portions of the market were owned by sophisticated investors, including governments, controlling families, and mutual funds, who presumably would not panic in a downturn and run for the exits.

Indeed, that peculiar species of speculator known as the day trader thought his mere presence on the scene precluded the possibility of a crash:

Ahmad Bin Ali believes that the many Saudi day traders like himself are reason enough to have little fear that the Arab world's biggest stock market will crash. . . . Ali has borrowed heavily to invest in stocks and counts on rising prices to service his debt. A sharp market correction would destroy him. "That won't happen," he said, sipping tea in a cafe in Manama. "There are too many people like me. The government can't afford to let it happen."
Many market watchers agree. A stock market crash would spell disaster for tens of thousands of investors across the Gulf Arab region. (Gulfnews.com, 3/4/2006, “Gulf Markets ‘Cannot Afford a Crash’”).

Then, this past February 23rd, the market “correction” began. In a matter of weeks, half the Saudi market value disappeared. To put this into perspective, it took two and a half years to achieve the same effect in the broad U.S. market from 2000 through 2002.

Here is a picture of the Saudi market from July 2005 through mid-June 2006 that illustrates the damage:

Dowries disappeared, weddings were postponed, and marriages ended. Local psychiatrists reported an influx of patients. (Asharq Alawsat, 5/18/2006, “Psychiatrists See Their Businesses Boom Because of Stock Market”) Thousands of Saudi citizens whom the government had wanted to help suddenly found themselves indebted for years to come. Even for American investors jaded by recent market declines, stock-analyst corruption, and mutual-fund scandals, such a reversal of fortune is breathtaking.

And yet one thing is certain: it will all happen again. And again and again. As the research in behavioral finance suggests, it appears that the very traits that helped us survive as a species have hardwired most people to be poor long-term investors. But this is a topic for another article. For now, suffice it to report that Saudi investors are continuing the post-bubble tradition of blaming everyone but themselves for their losses. There are public accusations of market manipulation, calls for tougher regulation, and complaints about the banks that profited from investors’ loans. Meanwhile, the ocean storms are likely right on track to their next destination.

It is sometimes tempting, I’ll admit, to engage in what is called “market timing,” a form of active management that involves buying and selling investments based on anticipated market moves. The temptation is greatest during market declines, since the allure of market timing is that it will help us avoid portfolio losses. And avoiding losses can seriously boost returns.

For example, according to recent data generated by the folks at Dimensional Fund Advisors, an investment in the S&P 500 Index over the past 36 years, from 1970 through 2005, would have earned a respectable 11.11%. But if we could have been smart enough to miss the worst day for the market, October 19, 1987, we could have boosted our overall return to 11.77%. Miss the worst month, October 1987, and we would have received 11.86%. And if we happened to miss the worst year ending September 1974, we could have increased our overall return more than 150 basis points (1.5%) to 12.64%.

That’s the promise, anyway, of market timing. But here’s the rub: in attempting to avoid the worst market days, it’s just as likely that we’ll miss the best ones too. Here’s what happens when we do:

In other words, by trying to gain an additional 150 basis points through market-timing moves, we could just as easily lose that much.

Well, you might reply, there were over 9,000 trading days from 1970 through 2005. So wasn’t there plenty of opportunity to make up for one or two bad timing moves? Not really. It’s very difficult to make up for even a few stumbles. As the table below shows, missing just a handful of days can seriously erode our portfolio growth:

Finally, consider just how easy it is to miss the good periods:

• The best single day was October 21, 1987 – just two days after the Black Monday market crash.
• The best one-month return, October 1974, happened immediately after the worst one-year period.

This close proximity of good periods to bad periods is what makes it so difficult to time the market well on a consistent basis. Thus, while it’s sometimes tempting to read the macroeconomic tea leaves and “tweak” portfolios in response to recent market events, it’s usually best to resist temptation. As Warren Buffett once stated in a Business Week article, “Success in investing doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”

**Time periods are based on monthly rolling returns. Indexes are not available for direct investment and their performance does not reflect the expenses associated with the management of an actual portfolio. This information is for educational purposes only and should not be considered investment advice. Past performance is not indicative of future results. Data is compiled from sources we believe to be reliable and current, but accuracy cannot be guaranteed.

FPA 2006 Nashville Conference
I’ve been invited to appear with two other advisors on a technology panel at the Financial Planning Association’s national conference this October in Nashville. I’ll be talking about the data-security and disaster-recovery benefits of web-hosted software programs and hope to pick up a few more good ideas to implement back at the office as well.

BFA Is Hiring
Despite being paperless, BFA’s desk runneth over, and I am hoping to hire someone this summer who can help with administrative tasks as well as various account-services functions. Ideally this person will have previous professional experience, understand how to navigate large financial bureaucracies with a smile, and be passionate about helping clients. If you know anyone who might be interested, please ask me for the detailed job description.