'Some things are best left undone'

By Jonathan Davis
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The Independent Online

At times like this, when investors are going through one of their edgy, nervous phases, and markets are very volatile, many investors seek comfort in past precedents. However, such exercises can often be disconcerting as well as reassuring. It is probably small comfort to be reminded that next Monday marks the 13th anniversary of the single worst week in the history of the modern stock market.

At times like this, when investors are going through one of their edgy, nervous phases, and markets are very volatile, many investors seek comfort in past precedents. However, such exercises can often be disconcerting as well as reassuring. It is probably small comfort to be reminded that next Monday marks the 13th anniversary of the single worst week in the history of the modern stock market.

As the table shows, the week of 23 October 1987, which was the week of the great Wall Street crash of that year, holds the distinction of being more than twice as savage a setback as any other we have recently experienced. It also stands as something of an epochal event in the long history of financial markets.

According to a paper in the Journal of Finance, statisticians have calculated that the probability of the stock market falling by 23 per cent in a day, as happened on Black Monday in 1987, was so remote as to be virtually impossible. Based on historic figures for the volatility of share prices, it would still have been odds against the market falling that much in a single day, even if the markets had been open and trading continuously from the day of Creation itself.

"In fact," reports Roger Lowenstein, in the book on Long Term Capital Management that I mentioned last week, "had the life of the Universe been repeated one billion times, such a crash would still have been theoretically unlikely", or so the number crunchers calculated. Yet of course it happened - which is all, one might suppose, that really needs to be said about those who rely on the past to guide their future actions.

Yet there is plenty of evidence that the stock market exhibits the characteristics of mean reversion: that over time periods of excess are generally followed by periods of stringency, and vice versa. Nor need it necessarily take a long time to materialise: the 10 weeks that followed the October 1987 crash were one of the best periods for equity investors ever, just as 1975, which followed a disastrous 1974, produced the best 12 month return, measured in percentage terms, that investors in the UK stock market have ever seen.

It is this constant tug between short-term volatility and the longer term pull of long-term average returns that make market timing both so attractive and so difficult a concept. Take a look, for example, at the graph, taken from the annual gilts-equity study produced by Credit Suisse First Boston. It shows the difference that being able to pick the ten best and worst weeks in the stock market since 1980 could have made to an investor's portfolio.

What it shows is an investor who successfully managed to avoid the ten worst weeks, but was otherwise fully invested throughout the period, would have ended 1999 with more than twice as much money (£8,325 versus £3,883) as someone who simply remained in the market through the entire period. By the same token, an investor who missed the ten best weeks in the 20-year period, but otherwise was always invested, would have ended with barely half as much again (£2,028). The gap between the eventual sum achieved by the good and bad market timers is of the order of 4:1.

How you interpret this finding goes a long way towards defining your stance and experience as an investor. The immediate reaction of most people is to say: "If only I could somehow pick out those ten worst weeks, and avoid them, I could double my money for virtually no effort." Or they might say: "If only I could pick the ten best weeks, and stay out of the market the rest of the time, how could I not fail to do well?"

If that is the position that you are tempted to take, then you can be sure you will find scores of brokers and salesmen who are all too keen to encourage you down this path. In fact, most investment advertisements are, to varying degrees, variants on this "if only" kind of argument. They are united in their appeal to investors' natural instincts and their reliance on hindsight as the best guide to the future.

In fact, the most rational response is to press the statistics a little harder, and add some probabilities. If you ask yourself: "What are the odds that I can pick the best 10 weeks for the stock market in a 20-year period?" it does not take long to realise that the answer is "very slim". If you add in the fact that most of the sharpest moves in the market come at times when markets are either excessively gloomy or excessively pessimistic, and you have to act in the opposite direction to the prevailing mood, then it becomes even less of an appealing proposition. (History does not record that there were many investors leaping out of bed on the morning of 24 October 1987, saying "this is the best time to invest that I have seen for a long time".) For most people, investing their own money, and without the iron convictions of a genuine contrarian investor, the true odds of being able to pick out the best weeks are very long odds against.

Considered in that light, the simplest and most compelling conclusion is the one you find in most of the investment textbooks, namely market timing is a great idea - but don't be tempted to try it. I don't go quite as far as Charlie Ellis, of Greenwich Associates, who says market timing "is a sin - never do it". But it is one of those things that in a life of virtue are best left undone.

Of course, the argument against market timing should not be confused with a different argument, which is whether or not you should cut or increase your exposure to the stock market for other reasons - such as impending retirement, a change in circumstances or simply a change in your appetite for risk. The longer you have enjoyed the fruits of the bull market, and the nearer you are to needing to realise what you have made from your investments, the more prudent it is to consider altering your exposure.

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