End of the (Long) Run?

Market timing challenges policy investing again

A debate is brewing in the investment community. The outcome will influence institutional managers and other financial technicians. It could change how pension plans and individuals invest.

The U.S. financial markets have taken investors on an emotional roller coaster since the late-90s. The historic advance, followed by a crash of similar magnitude and enduring bear market, shook many investors’ confidence in policy investing. (See “What Is Policy Investing?” below.) The market trauma and rising uncertainty have resurrected a few ideas that are dressed up as new, innovative approaches to investing. The advancement of market timing as a serious investment tool is one example.

Market timing and the professionals who practice it have a long history on Wall Street. But the technique has never entered the financial mainstream due to its questionable tactics and lackluster track record. What’s different now is that more prominent financial managers, including Peter Bernstein, the highly acclaimed author, economist and proponent of Modern Portfolio Theory, claim that market timing has a legitimate role in portfolio management.(1)

Their reasoning goes like this: The precepts of modern finance arose during an exceptional time in U.S. market history, when the stock and bond markets were riding a long-term bull market trend. But the rules have changed—and today’s market conditions have no historical precedent. Therefore, building investment strategy upon long-held financial assumptions may not deliver good results in the future.(2) According to Bernstein, “the long run doesn’t work” in today’s weird market. Let the diversified, buy-and-hold investor beware.

This is an earth-shaking statement, considering his support of MPT and industry clout. Bernstein and other market timing converts are now questioning the principles upon which they managed portfolios for many years. This philosophical shift has implications. Policy-based asset allocation may lose prominence while forecasting, short-term trading and other market timing actions gain credibility with institutional and individual investors.

The problems with timing

Don’t discard policy investing just yet. Market timing may seem logical and smart in theory. But it falls apart in practice. Here’s why:

Prediction is elusive: The 2003 market surprise illustrates the challenge of forecasting how events will impact investments. Despite record-low interest rates and pro-growth tax policy, the economy struggled through the first half of the year. High unemployment, terrorist alerts, Iraq invasion, the SARS epidemic, corporate scandals, rising tariffs, swelling budget and trade deficits, a falling dollar and climbing energy prices added to the uncertainty.

Advance knowledge of these events would lead a timer to expect higher interest rates, a stalling economic rebound and a falling stock market. So, what happened? The economy and stock market surged in the second half of the year. The Wilshire 5000 returned 29.4% and the S&P 500 advanced 26.3%.(3)

Active management isn’t free: Research, analysis, forecasting and trading raise portfolio expenses and may increase your tax bill. These costs erode total return while often injecting even more risk into the portfolio.

Timing feeds the wrong behaviors: The hardest part of investing is staying with the long-term plan when the market is performing at either extreme. But investment staying power, when combined with skillful portfolio design, can help build long-term wealth. Investment policy helps enforce discipline; market timing preoccupies investors with short-term market moves and forces defensive actions, often at the worst possible times.

Poor timing misses the advance: To get long-term return, you must own asset groups before they move—and movements typically occur in short, unpredictable spurts. Consequently, a small timing mistake can have a disproportionately large impact on return.

Ironically, timers claim that they add the most value when markets are the most unstable. But how can this be the case? If markets, assets and the economy are becoming less predictable, how can more prediction and speculation stabilize a portfolio? It would seem more rationale to spread the risk through diversification. This is the advantage of following policy rather than chasing emotions and hunches.

What Is Policy Investing?

With roots in Modern Portfolio Theory, policy-based investing emphasizes financial goal setting, risk reduction, portfolio diversification and long-term discipline over aggressive trading and market timing.

Asset allocation is the main tool for implementing investment policy in a portfolio. After defining long-term financial goals, risk tolerance and funding ability, an investor documents this plan and builds a diversified portfolio that holds many asset groups or “classes” in both the U.S. and international markets. (Examples include large and small-cap stocks, value and growth stocks, emerging market stocks, fixed income instruments, real estate and tangible assets.) The classes are chosen according to their historical risk and return characteristics, as well as their expected performance relative to one another—a trait known as return correlation. (Lower-correlation assets have more dissimilar performance, which can reduce portfolio volatility and stabilize total return.) The final asset mix should reflect an investor’s unique risk-return profile.

Policy-based asset allocation assumes that asset mix—and not individual stock selection or market timing—determines most of a portfolio’s total return. So, staying power is critical to building long-term wealth. A detailed and documented investment policy helps keep investors committed as markets rise and fall. This prevents panic selling in a bear market and feverish buying in a bull market. Policy investing does allow certain forms of active management. For example, a portfolio must be rebalanced over time to realign asset mix with the original policy allocation. Also, an investor’s changing risk tolerance, financial needs or return goals will merit fundamental changes to the asset mix.


(1) “Bernstein’s Shocking Words: Market Timing”, The Wall Street Journal, 27 Aug. 2003, C1.

(2) The basic premise is that U.S. equities will deliver below-normal returns over the next decade; fixed income investments will underperform when interest rates begin an upward trend; asset groups won’t behave as they have in the past; and the pace of economic and market changes will quicken.

(3) Many other asset groups across the globe performed as well or better. The Wilshire 5000 is a broad indicator of U.S. stocks; the S&P 500 is an index of large company U.S. stocks. You cannot invest directly in an index. Past performance does not guarantee future results.

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