After bottoming out in March 2020, equities have enjoyed a strong recovery and today some investors see stocks as being fully valued, if not expensive. Your clients may be asking you if now seems like a good time to de-risk their portfolios.
My usual response to this question has been, “Wait – that’s market timing, which is always a bad idea.” But perhaps it’s time to reconsider comparing de-risking with market timing. Reducing a portfolio’s risk level isn’t always equivalent to timing the market, and there may be sensible reasons to do so.
Generally speaking, market timing attempts to mitigate market declines by repositioning assets, often to lower-risk asset classes, until equity markets recover. Someone who times the market is trying to construct a portfolio with very low downside capture and a very high upside capture rate. In essence, the process is buy low, sell high, buy back low, sell high, rinse and repeat.
That description might lead one to wonder why market timing has gotten such a bad name. The practice does have some well-documented pitfalls. Markets can give many false signals that can cause an investor to sell prematurely; and declines are relatively frequent, but their severity varies. For example, market dips (e.g., declines of 5-10% from a peak) and corrections (declines of 10-20%) happen significantly more often than bear markets (declines greater than 20%). An effective market timer needs to predict how severe a decline will be, so that they can ignore the head fakes and move out of equities before a large decline.
This is problematic, since you can’t be sure you’re in a bear market until stocks have already fallen 20% and waiting for confirmation of a serious decline almost guarantees that you’re selling too late. Furthermore, deciding when to get back into the market presents even more difficulty, since market bottoms often occur when fear and pessimism are high. Buying low is usually much harder than it might appear with the benefit of hindsight.
There are behavioral biases that come into play as well. Hindsight bias, for example, refers to our tendency to view events as more predictable than they really are, and helps us understand why market timing can be so tempting. Looking at past market patterns, it’s almost impossible not to imagine how well an investor could have performed if only they had been able to avoid the big declines yet still experience market gains. Who wouldn’t want to have their cake and eat it, too?
Further compounding this issue is our human tendency to focus on the few investors who actually did predict and profit from the last bear market, while conveniently ignoring the vast number who did not. Remember, the average person does not see themselves as average. Instead, they often see themselves as better looking, or smarter, or a better driver than the “average” person. Similarly, I think the average investor believes they are somehow skilled at stock selection and timing markets, even in the absence of evidence. An average investor might think, “Sure, the ‘average’ investor should avoid that dangerous practice of market timing, but I can defy the odds and do it successfully.”
We humans have a bias for action when confronted with a threat. So when facing a potential bear market, nobody wants to endure potential loss. This kind of thinking can lead to counterproductive investor behavior. In addition to the opportunity costs that can result from head-fake market dips that never become bear markets, clients may be tempted to make big portfolio changes without considering the consequences. After all, if you believe that the market is about to crash, why wouldn’t you move to 100% cash? People discount the implications to their portfolio if they’re wrong.
The idea that market timing is possible represents a proverbial Pandora’s Box, because if you think that you can do it, then many investors will make the leap to arguing that you should do it. If we as advisors push back against their wishes, clients might then question the quality of our advice or even our motives. In response, we may be tempted to simply dismiss the practice altogether, saying that market timing doesn’t work and that it’s a dangerous fool’s errand. After all, our intentions (helping protect clients from their own maladaptive behaviors) are honorable ones, so whatever we can do to stop them from even considering trying to time markets can be justified.
Here’s another way to address the issue. First, we should educate our clients about how markets and people actually behave. If they can understand how frequently dips, corrections, and bear markets occur, that may help them realize the virtual impossibility of predicting bear markets in advance. We can also inform them about behavioral biases that can prompt investors, including us, to make significant unforced errors. It can also help clients understand why we try so hard to keep them from shooting themselves in the foot. We can acknowledge that clients are tempted to think they can time markets, but also justify our assertion that they’re likely better off resisting those impulses.
It may also be helpful to shift clients’ focus from maximizing reward to managing risk. I think that when clients are myopically focused on maximizing gains, they view investing as a game where the goal is to accumulate as many points (dollars) as possible. When this is their dominant mindset, they may shift from investing to speculation and become more susceptible to unproductive investor behaviors.
If managing risk becomes the focus, though, the likelihood of making costly behavioral mistakes may be reduced. Managing risk doesn’t mean minimizing risk—that could be achieved by using a high-quality money market fund. Instead, it means broadening the investor’s perspective to consider other factors besides potential upside such as volatility of returns, likelihood of non-recoverable losses, and the current market environment. To me, this last area represents an opportunity to incorporate an alternative to market timing in a way that might help clients scratch that particular itch.
As we know, most major asset values are cyclical. This isn’t limited to bull and bear markets, but encompasses markets that alternate between favoring and disfavoring different asset classes, styles, sectors, and geographies, to name a few. For example, SEI has written a number of pieces discussing a recent shift in stock market leadership from growth to value. Historically, such trends have persisted for a time and then eventually reversed. The catalyst for a trend’s reversal may be a change in the economic environment, often accompanied by the broadening recognition that a particular type of asset has gone from having attractive valuations to being fully valued or outright expensive.
This has important implications for risk management. Nearly all trends eventually reverse, so the longer a trend persists, the more risk you assume by investing as though the trend will persist indefinitely. Having a contrarian mindset can prove beneficial, especially when there is a growing belief that “it’s different this time.” For example, we can deploy a portion of our portfolios into assets that are expected to benefit when an unusually persistent trend moderates or reverses. We aren’t trying to predict when the reversal will occur, but rather seeking to mitigate that risk ahead of time instead of simply reacting.
I think it’s always prudent to go back to an investor’s goals to frame what success should look like. As one advisor told me, “If you’re winning by 4 touchdowns at halftime, you don’t have to run up the score.” Investing isn’t a game where the goal is to squeeze out every last gain possible. Rather, it’s more helpful to view it as a means to help achieve investor-specific goals, which means being mindful of risk in its many forms.
A few more suggestions to consider:
- Understand history, but don’t be bound by it. Investments usually have an element of cyclicality, but they’re not completely predictable.
- Discuss behavioral biases, including your own, as a way to preach humility. We need to recognize our limitations as investors and shouldn’t assume that we’re all above average. This is relevant to both market timing and the potential benefits of diversification.
- If warranted, consider using rules-based changes (e.g., rebalancing, dollar-cost averaging, and incremental profit-taking when equity markets gain a predetermined amount). This helps de-emphasize reliance on timing, and implementing objective processes can help mitigate investor bias.
- Set expectations that portfolios should change meaningfully only when investors’ goals or risk tolerance change for good reasons (e.g., after retirement). Contrarian/opportunistic tilts can play a role, but more on the margins as opposed to big bets.
If we discuss the hazards of market timing in a tone that is less dismissive and more educational, clients are probably more likely to listen and act on our recommendations. Ultimately, I think this can only strengthen trust, and enhance the quality and impact of our advice.
Investing involves risk including the possible loss of principal. There is no guarantee risk can be managed successfully. Diversification may not protect against market risk.
Upside capture is the statistical measure of an investment manager's overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen.
Downside capture is the statistical measure of an investment manager's overall performance in down-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has fallen.
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