Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 56

Squiggly lines and lessons in market timing

The ability to forecast market or stock returns is a holy grail in investment management. The search has captivated industry and academia. Many smart people have devoted their careers to the search, large teams of highly talented people have been assembled, and elaborate models have been developed. We have even seen examples of such work in Cuffelinks! Many of these endeavours have failed, sometimes spectacularly.

And yet so many are tempted to continue in their quest to develop a model or process for predicting market returns. It appears to me that the desire for precision, to be close to exact in one’s forecasts, often contributes to the downfall of people taking on this quest.

If we step back to a higher, less specific view, take on board key messages (for example that markets appear cheap or expensive), diversify appropriately, and invest for the long term (with a matched frame of mind for assessing outcomes) then the world of managing a portfolio becomes a simpler and less high-stakes exercise.

Models and processes for forecasting markets generally fall into two broad categories:

  • fundamental – where one considers the economic (market) or financial (company) prospects and estimates the value of these prospects in the context of current market prices
  • technical – where one solely looks at past price data in search of patterns that may repeat in the future. Common examples include trend following and mean reversion.

It is common to see both techniques used together. It doesn't matter whether the process is fundamental or technical; the same problems apply when we search for the exact model.

Here’s where the squiggly lines come in. You can try this exercise yourself.

1. Draw a squiggly line which represents the movement of a stock price or market index through time. Connect the start and end points of the squiggle with a straight line.

One might be tempted to look at the straight line and observe that it summarises the trend movement in the market. It might appear logical to say with hindsight, “there are clear buy and sell opportunities”.  It might lead to a trading rule: when the price is a long way above or below my trend line, I will sell or buy.

The example above could be something as simple as an expectation that equity returns will annualise 8% p.a. If they run too far ahead or behind this level then this is an opportunity to sell or buy.

2. Continue your squiggly line a little further into the future and extend the straight line derived in the previous example.

3. Let’s assume we follow our little trading rule developed in step 1 into the future.

In the case of my diagrams above (yours would be different of course but you likely experienced less-than-perfect outcomes as well), it looks like our little timing model didn’t work too well.

On reflection we may begin to realise that the opportunities identified in the second diagram are only available to people in possession of a time machine. It is only with hindsight that we can observe this historical relationship. The fallacy is to bet on this relationship continuing exactly in to the future.

4. Because we now have more market observations perhaps we should review our model. We find the slope of our line (which explains the relationship) has changed (become flatter in this case – the new line below is unbroken and the original line is dashed). With perfect hindsight we would have traded differently.

The fact that the slope changes as we progress through time is the downfall of this type of approach, and indeed any approach that looks backwards. It is easy to say “history doesn’t repeat but it does rhyme” but simple analysis like this highlights that what we may have is an off rhyme.

Indeed it is risky to assume that there are any precise permanent relationships in finance. Even something like the equity risk premium has changed significantly through time and can be affected in uncertain ways by many externalities such as demographics, technology, politics and environment.

Technically the slope in our diagram is known as a parameter in a forecasting model. The fact that the slope can change through time and that we do not know the true value of the slope is called parameter uncertainty. Assuming a parameter or a relationship is stable when in fact it may evolve through time is dangerous. This uncertainty is everywhere but not really well considered when constructing diversified portfolios. For instance, is the equity risk premium 4%, 6% or 8%? Is it even appropriate to assume it is constant over the long term?

There has been much academic and industry research demonstrating that if we are uncertain of the true values of a parameter (the slope in this instance) we should allocate less to this investment opportunity ie. it is sensible to diversify.

It is possible to extend the findings of this example to more complex models in which multiple variables are used to describe market performance. A common example is the use of dividend yields to forecast market or individual stock returns. The more factors we have the greater the number of model parameters and the greater the number of sources of parameter uncertainty.

What are the lessons?

So what lessons should we pull out from this collection of squiggly lines?

  • History is just that and could be far from an accurate forecast of the future.
  • There are however valuable observations and lessons to be drawn from history.
  • Any model based on an historical relationship would have worked perfectly in hindsight. But we don’t have a time machine and we are not bestowed with perfect foresight.
  • Once we acknowledge the uncertainties introduced in forecasting markets it is easy to understand why it remains sensible to diversify and take a long-term outlook.

No one knows precisely which way markets or individual stocks will perform. The best we can do is to research deeply and tilt the odds in our favour, especially over the longer term. In searching for precision we may actually construct portfolios which subsequently disappoint. These are valuable lessons for selecting managed funds and constructing portfolios.

 

David Bell’s independent advisory business is St Davids Rd Advisory. In July 2014, David will cease consulting and become the Chief Investment Officer at AUSCOAL Super. He is also working towards a PhD at University of NSW.

 

RELATED ARTICLES

Cheap stocks: how to find them and how to buy them

Technical versus fundamental analysis in equity markets

You the speculator

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

Policy proposals allow young people to access their super for a home bought from older people who put the money back into super. It helps some first buyers into a home earlier but it may push up prices.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.