You can time the market – here’s how

Timing the market buying on the lows, and selling on the highs is usually seen as a mug's game. None of us can predict the future, after all. The fund-management industry often abuses this fairly sensible argument as a way to persuade investors that they are better off with passive buy and hold' just keep your money in the market all the time (and hence in their funds, generating management fees).

But Mebane Faber, portfolio manager at Cambria Investment Management, thinks differently. He thinks that, over the long run, if you use the right timing strategy, you can generate "equity-like returns with bond-like volatility". In other words, you get more reward while taking less risk. So how does it work?

Market timing is all about choosing the right moment to move in and out of an asset class, rather than just allocating a static, say, 60% of your portfolio to shares and 40% to bonds. Faber's technique employs the ten-month simple moving average (SMA).

A moving average is just a way to express monthly share prices so that volatility is smoothed out, giving you a better feel for the underlying direction of the market. Say the FTSE 100 records the following closing levels over three months 6,000, 6,200, 6,300. The average closing level is 6,167 (6,000+6,200+6,300)/3. If the index closes at 6,400 in month four, then the three-month SMA rises to 6,300 (6,200+6,300+6,400)/3. For a ten-month SMA, you would use ten months of data, rather than three.

Using Faber's system, if the stock market ends the month above its ten-month SMA, then you follow a 100%-stocks strategy the next month. If it finishes below the ten-month SMA, you shift to 100% bonds. In my simple three-month SMA example, you would be invested in stocks in both months as the market is rising, so the latest reading is above the SMA.

Applying this timing method to US shares (as represented by the S&P 500) between 1926 and March 2013 produces some eye-popping results: an annualised average return of 11.9%. That compares to 8.7% for a portfolio split 60/40 between shares and bonds; 9.9% for an all-share portfolio; 5.7% for an all-bonds portfolio, and 3.7% if you had stayed in cash. What is even more interesting is that the risk (the standard deviation) involved is similar to that incurred on a 60/40 portfolio, and substantially below that of an all-shares portfolio. What's more, the maximum drawdown' (your biggest paper loss over that time) for the market-timing strategy is only bettered by being in either bonds or cash.

Sounds great. So what's the downside? A rolling monthly market-timing strategy does require more effort than a simple buy-and-hold approach. It also incurs more cost of the 1,037 months evaluated in the study above, you'd have been switching between stocks and bonds 123 times, or 12% of the time. The costs of making these switches would make a dent in your returns. And if you do choose to time the market in this way, you have to ensure that you follow your own rules if your indicator says switch', then you must switch, regardless of what your gut' tells you. Nothing messes up an active strategy like mapping out a sensible plan and then failing to stick to it.

Nonetheless, it appears that active investing, even when the strategy is a pretty simple one, can beat the lazier approach of buy, sit back and wait.

Four investing traps to avoid

"Never try to teach a pig to sing; it wastes your time and annoys the pig." Finance blogger Barry Ritholtz attributes this quote to a farmer but it applies equally well to investors as to agricultural workers. We've all clung onto a losing share when the evidence suggests the facts have changed, and our reason for buying is invalid. We want that pig of a stock to sing, but it never will yet we refuse to sell. Here are four other classic errors to avoid.

Don't cling to the past

I held off buying a London property for far too long early in my career because friends had lost money in the early 1990s crash. As a result, I missed a big chunk of the bull-run that began around 1994.

Don't confuse luck and judgment

When we make money, we think we're clever. When we lose money, we think we were unlucky. We simply don't like to admit that we're wrong. So always write down your original reason for investing, then refer back to it when you decide to sell. Did you really expect that bid for one of your shares to push the price up by 50%? Probably not.

Understand opportunity cost'

Every £1 invested is £1 that could be earning a return elsewhere. So paper losses from holding a losing share do have a cost that cash could be earning more sitting in a plain old bank account.

Don't be framed

Company bosses like to direct your attention to headline numbers the ones they want you to see. For example, they will highlight an easily manipulated profit figure, such as earnings before interest, tax, depreciation and amortisation (EBITDA), when you should focus on the firm's awful cash flow instead. Equally, fund managers quote performance figures that flatter them, but hide big costs. In both cases, they are 'framing' your view. The solution? Become as well informed as you can and maintain a healthy scepticism towards the professionals.