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

Howard Marks on the best opportunities in 2024

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

Technical versus fundamental analysis in equity markets

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Planning

What will be your legacy?

As we get older, many of us start to think about how we’ll be remembered by those left behind. This looks at why that may not be the best strategy to ensure that you live life well and leave loved ones in good stead.

Economy

It's the cost of government, stupid

Australia's bloated government sector is every bit as responsible for our economic worries as the cost of living crisis. Grand schemes like the 'Future Made in Australia' only look set to make it worse.

SMSF strategies

A guide to valuing SMSF assets correctly

SMSF trustees are required to value all fund assets, including property, at market value when preparing the fund's financial statements each year. Here are some key tips to ensure that you get it right.

Economics

Australia is lucky the British were the first 'intruders'

British colonisation's Common Law system contributed to economic prosperity, in contrast to Latin America's lower wealth under Civil Law. It influenced capitalism's success in former British colonies, like Australia.

Economics

A significant shift in the jobs market

The expansion of the 'care sector' represents the most profound structural change to Australia's job market since the mining boom. This analyses how it's come about and the impact it will have on the economy.

Shares

Searching for value in tech stocks

Just because a stock is cheap doesn't necessarily make it good value. This uses case studies in the tech sector to help identify when stocks trading on 30x earnings may be inexpensive and when others on 10x may be value traps.

Investing

Are more informed investors prone to making poorer decisions?

Finance Professor Michael Finke recently discussed the double-edged sword of taking an interest in your investments, three predictors of panic selling, and why nurses tend to be better investors than doctors.

Sponsors

Alliances

© 2024 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.