Market Timing

Consider the results of three different investment strategies, as gleaned from Table 5.3:

Investor X, who put $1 in 30 day T-bills (or their predecessors) on January 1, 1926, and always rolled over all proceeds into 30-day T-bills, would have ended on December 31, 2001, 76 years later, with $16.98.

Investor Y, who put $1 in large stocks (the S&P 500 portfolio) on January 1, 1926, and reinvested all dividends in that portfolio, would have ended on December 31, 2001, with $1,987.01.

Suppose we define perfect market timing as the ability to tell with certainty at the beginning of each year whether stocks will outperform bills. Investor Z, the perfect timer, shifts all funds at the beginning of each year into either bills or stocks, whichever is going to do better. Beginning at the same date, how much would Investor Z have ended up with 76 years later? Answer: $115,233.89!

What are the annually compounded rates of return for the X, Y, and perfect-timing strategies over the period 1926-2001?

These results have some lessons for us. The first has to do with the power of compounding. Its effect is particularly important as more and more of the funds under management represent pension savings. The horizons of pension investments may not be as long as 76 years, but they are measured in decades, making compounding a significant factor.

The second is a huge difference between the end value of the all-safe asset strategy ($16.98) and of the all-equity strategy ($1,987.01). Why would anyone invest in safe assets given this historical record? If you have absorbed all the lessons of this book, you know the reason: risk. The averages of the annual rates of return and the standard deviations on the allbills and all-equity strategies were market timing

Asset allocation in which the investment in the market is increased if one forecasts that the market will outperform bills.

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