Investors have access to basic tools that can allow them to make investment timing decisions, minimizing—not eliminating—emotions during the process. If you’re inclined to believe that it’s impossible to time the market, than please read last week’s article, "Objective Investing Decisions." Minimally, please read through to the end of this article.

Investing decisions are extremely personal with both individual constraints such as time horizon and preferences such as true risk tolerance varying across people who may seem to have similar financial situations. Investors participating in the US stock market in 2007-2008 likely got a better sense of the notion of “true” in their risk tolerance. Even now what you think is acceptable risk may change with a decline in the market.

Given the personal nature of investing, keep in mind that the examples here are intended to provide a framework for you to make decisions appropriate for you. There is no one size fits all and this could not possibly serve as any kind of recommendation. Ideally this information is sufficiently clear to allow you to do just that.

Timing versus No Timing

The timing approach discussed here monitors the closing value of the Dow Jones Industrial Average [DJIA] at the end of the month and identifies conditions as bullish or bearish. This determination is used for the timing decision the next month. There are two different ways an investor can use the timing concept:

1. Use the bullish/bearish designation to be 100% invested in the stock market or 100% in cash. This approach is the more aggressive of the two from a timing perspective and the 100% refers to the allocation you’ve already identified for the stock market from your investable assets.
2. Identify two different stock allocations, one that is more aggressive and one that is conservative. This approach is the more conservative of the two from a timing perspective and uses the more aggressive allocation when conditions are bullish and the conservative allocation when conditions are bearish.

It’s important for you to determine in advance which approach you may use and what constitutes a conservative versus aggressive allocation for the 2nd method. Keep in mind that you can also track the performance of either method on paper before implementing it. This approach is referred to as a forward test and my help you gain comfort with the process.

Timing Approach 

The timing approach looks at two values for DJIA at the end of the month:

1. The average value for DJIA over the last 50 trading days, and
2. The average value for DJIA over the last 200 trading days.

These two values are available from many websites and are referred to as the 50-day simple moving average [SMA] and the 200-day simple moving average.

When the 50-day SMA is more than the 200-day SMA, conditions are considered bullish. The allocation is then either 100% in stocks or uses the more aggressive allocation amount. When the 50-day SMA is less than the 200-day SMA, conditions are considered bearish. The allocation is then either 0% in stocks or uses the conservative allocation amount.

Using some shorthand: 
50-day SMA > 200-day SMA à Bullish
50-day SMA < 200-day SMA à Bearish

You can find the SMA values on stock charts available from Yahoo!Ò Finance and accessing a DJIA chart by requesting a quote for “^DJI”. When the quote is obtained, click on the chart provided and use the “Technical Indicators” drop down menu to check Simple Moving Average. This will allow you to include two SMAs. As a last step, select a six-month view (denoted as “6M” on a tab below the chart). This will provide daily information.

To identify bullish versus bearish conditions, note the color of the two SMA lines that appear on the chart and determine which value is greater. If the two lines are close, use the chart legend to obtain the exact values for the last day of the month. The following link may also help you navigate these steps:

http://finance.yahoo.com/echarts?s=^DJI#chart8:symbol=^dji;range=6m;indicator=sma(50,200)+volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

No Timing Approach

The No Timing approach is used to describe a portfolio that remains at a 100% stock market allocation for the entire period identified. There is no bullish/bearish designation.

Important Comments on the Testing Method

There are a few important things to note for the results you review here.

These are important considerations for any method you assess—you want to know what the results reflect. Please contact me on my discussion board for any other clarifications.

Bearish Periods

Figure 1 provides a monthly view of the Dow Jones Industrial Average^SM [DJIA] with bearish periods as designated by the timing approach highlighted in blue. During these periods the individual is not invested in the stock market.


Figure 1: Dow Jones Industrial Average Monthly Closes with Timing (1986-2009)

One of the main benefits time affords investors is the ability to ride out downturns since over the longer-term, markets move upward. That is probably something you’ve come to accept over the years as an investor. Market returns tend to be smoothed when considering longer periods of time which reduces some of the downside return measures. This is likely due to the fact that bear markets generally last a shorter period of time than bull markets.

Last week return data for a series of ten-year periods from 1916–2009 was provided. The results used each possible start date over the 93-year period by beginning with the ten-year period from 1/3/1916 through 1/4/1926, then moving forward one day at a time. This makes use of overlapping data, but also considers an investor entering the market on every day possible. The process generated 21,103 sets of ten-year period returns. Returns were provided over a holding period that included the entire ten-year period and also those that were annualized.

This week a similar approach is used to look at a five-year time horizon. Since more five-year sets can be generated, there were 22,353 data points. Tables 1 & 2 provide side-by-side return results for both the ten-year and five-year periods.

 

Table 1: 10-Yr & 5-Yr Rolling Returns, No Timing versus Timing (1916-2009)

The five-year returns display maximum gains that were 75% of the No Timing approach while losses were only 63% of the No Timing approach. The Timing approach also reduced the portfolio volatility reflected in the StdDev, or standard deviation, measure.

 

Table 2: 10-Yr & 5-Yr Rolling Returns (Annualized), No Timing versus Timing (1916-2009)

The last table reduces the holding period further to three-year. Using the same rolling approach, there were 22,848 three-year periods available from 1916 through 2009.

 

Table 3: 3-Yr Rolling Returns Total Period & Annualized, No Timing v Timing (1916-2009)

It’s quite possible that the less time you have, the more you need to investigate the use of a timing approach if you choose to stay in the market. Since a shortened time horizon could conceivably heighten emotions, a timed approach should be one that is objective so you can minimize emotions in the decision-making process. They will still affect you, but you’ll have a much clearer answer to the dilemma “What should I do?”

This study is not intended as advice for anyone. No doubt there are better combinations than a 5-day and 200-day average value for the Timing approach. The goal is to provide investors with a view that is different than conventional approaches that may be held out as the only way to go. Please also review last week’s article for more information on the topics discussed here.


Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.