Risk On, Risk Off

 

Written by Peter Eickelberg

2011 and 2012 have displayed what market commentators call a “risk on/risk off” environment. In other words, investors as a group seem to move between “risky” assets such as stocks and lower-quality bonds and “safe” US Treasury debt in a volatile cycle of worry and relief that echoes the extremes of 2008 and 2009. An obvious question that arises is whether it makes sense to play the bounces to add returns in a market that can’t sustain a long-term rally.

First, to give credit where credit is due: If you can sell after a rally and buy after a dip, you have a winning strategy on your hands. There is no denying that good timing enhances your returns and reduces your losses. In fact, the more volatile the environment, the greater your profits. Right now investors feel like spectators at a tennis match watching the news volley between crisis and hope for Europe. We have become accustomed to large daily swings. Wouldn’t it make sense to sell after every good news rally and buy after every bad news pounding?

Stocks display something called “momentum,” which refers to how they trend upward or downward for a time during a rally or selloff. Over longer periods markets also tend to “revert to the mean.” This means that if general market levels get too high, a correction becomes likely; similarly, a recovery rally often follows a panic. So right there you have two ways to time the market: follow the (mini-) trend or bank on a snapback. The problem with both is that we lack specific, testable rules for how or when such movements will materialize.

Find someone who has successfully beaten the market in the short run, and you will usually find a gambler. Casual timers cannot point to a clearly defined, repeatable process that always works. The winners–you typically don’t hear from the losers–may indeed have called the most recent bottom or sold at the top, but when asked how they made the decision, you’ll most likely either get a murky answer that has no practical application or a simplistic rule of thumb that makes it sound easy. Too easy.

A quick read of so-called behavioral finance literature will reveal several biases that drive investor behavior. Overconfidence refers to our natural tendency to credit ourselves with superior skill so that we take higher risks than a purely logical investor.  For example, one study reported that more than 50% of survey respondents considered themselves “above average” drivers. You cannot have more than half a population above average, so somebody in this study must be deluded. You can easily imagine traders believing they have a special skill to outsmart other investors. And when they call it right, “confirmation bias” supports their overconfidence.

We also tend to feel best about buying when markets are advancing. Why is this? One explanation involves the “herding tendency,” which means we like to be part of the “in” group. Herding bias can help lead to investment bubbles as new market entrants imitate what other successful investors have already done. In fact, as one author points out, a desire to go with the flow might explain part of our “hunches” about the market.  

In addition, we want to feel proud of our decisions and avoid the pain of regret. Knowing this, one must question whether a person boasting of recent timing success has an equal number of poorly timed decisions buried away subconsciously. A useful exercise would be to gather data on all active timing decisions and to compute the average return to see whether timing truly added value over time.

A recent story called “The lopsided bet” discusses a study which did exactly that. The study’s authors found that 86% of “active” funds (funds which employ a manager to pick stocks and make timing decisions) underperformed a market-equivalent fund over time. We’re talking about professional money managers here. Not only did their funds underperform, but they very likely charged more for the service. It has been our observation that many individual managers get a “hot hand” for a while but soon fall behind. To profit from their good times, you have to find the winning managers before they come into favor or you will just chase performance, which is what many investors do to their own harm.

To conclude, we do realize that good timing can add value. In fact, you owe it to yourself to think about the current market environment before deploying capital. When we manage money, we also consider what we know about current market conditions and occasionally do make shifts based on what seems most likely over the near-term horizon. But we must always recognize that timing decisions represent guesses, nothing more. We know of no reliable system or foolproof method to call the market ups and downs. Making short-term calls with a small amount of your “speculative capital” could help you scratch that itch and may even make you some money once in a while. But in light of the odds, we believe most investors are better served by having most investable assets in a diversified long-term plan designed to ride out the good and bad times.

Posted in Cross-Border Blog
Cross-Border Series
The Border Guide
Now available in its 11th edition, The Border Guide has sold over 80,000 copies and is considered the definitive cross-border financial tool for Canadians living, working and investing in the United States.
A Canadian's Best Tax Haven
This book will show you how to realize your dream of living a lifestyle in a climate that allows for year-round golfing and sandy beaches while lowering your taxes and cost of living.
Taxation of Canadians in America
This book addresses individual US taxation and estate planning issues you will face as a Canadian living in the US.
Taxation of Americans in Canada
US citizens and green card holders are subject to US tax regardless of where they reside in the world. Are YOU at risk?

Crossing the Border?
TRY OUR CROSS-BORDER FORUM »
Get Updates from Us
SIGN UP FOR E-UPDATES »