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Craig Allen: Key Differences Worth Noting in Market Timing vs. Tactical Trading

Despite investment industry pronouncements, cash can be an asset class

Over the years I have witnessed a major shift from transaction-based, trading strategies to asset allocation-based “buy-and-hold” oriented strategies. In fact, “market timing” has been widely shunned by most market participants in recent years. The mere mention of market timing these days conjures up an immediate negative reaction from most investors. But before we completely turn our backs on any investment approach, we should more clearly define what is meant by market timing, so we don’t make the mistake of completely ignoring a potentially valuable investing technique.

First, let’s understand what most investors think when they hear market timing . Over the years, many studies have shown that, in essence, investors can’t beat the market, meaning that virtually any trading strategy, over time, would not outperform the market index, such as the Standard & Poor’s 500. In fact, the Efficient Market Hypothesis states that stock price movements are random, meaning they cannot be predicted, so it follows that trying to time the market is pointless and will not improve performance.

The investment industry has fully embraced the notion that market timing doesn’t work. In fact, just about any financial consultant at any major firm will recommend some form of asset allocation approach that is predicated upon what is essentially a buy-and-hold strategy — dividing a portfolio among the various asset classes, based on the Efficient Frontier, and making minimal adjustments to the allocation over time.

Here is what is interesting to me: If you think about it, any strategy, such as the one described above using the asset allocation approach, could be considered market timing, depending on how one defines market timing. For example, as just described, most asset allocation approaches require periodic rebalancing or adjusting. What is that rebalancing based upon, you may ask? It is based on the relative performance of the various asset classes that make up the asset allocation. In simple terms what this means is that, as the market changes over time, the various asset classes change in value relative to each other, and at some point must be adjusted. Well, that is market timing! The person making the decision as to when to rebalance is essentially choosing a time when he or she believes that some asset classes are overvalued and others are undervalued, and sells some or all of those that are believed to be overvalued, and buys some or all of those believed to be undervalued. That, again, is market timing! At least I would define it as such.

I would say that any strategy other than a true buy-and-hold plan, where nothing is ever bought or sold, is the only strategy that does not involve market timing to some degree. However, in the strictest definition, market timing is an aggressive strategy of investing the entire portfolio when values are believed to be low and selling everything when values are believed to be high, and/or when the market is expected to sell off. Under that strict definition, market timing would not be appropriate for many investors and I would submit that it would not work.

Before we completely dismiss market timing altogether, I would like to more clearly differentiate market timing, in its strictest sense, from tactical trading. I use tactical trading and have for many years. While some would define tactical trading as a market-timing strategy, and I would not necessarily disagree with that definition, I believe that tactical trading is not only appropriate for most investors but can result in enhanced returns over time. In fact, I have used tactical trading in my model portfolio — the MPAM Model Growth Portfolio — with great success over time (since inception in 2004).

Tactical trading involves an analysis of the overall market and economic conditions at present and in the future, and making changes to portfolios based on those conditions and expected conditions. By selling portions or portfolios when valuations are extended and market and economic conditions are not favorable, and then reinvesting the cash raised when markets decline to more attractive levels when market and economic conditions are believed to be more favorable, returns can be improved dramatically. This is what I do, and it works.

Most investment professionals shun cash because they believe that investors, if they sit on cash for too long, will pull their money and send it to someone else who will immediately invest it. In many cases, they are probably right! Most investors have been programmed (brainwashed) to believe that money should be invested at all times. This goes back to the same efficient market studies that were mentioned above; the belief is that if you can’t time the market, and if the market is truly efficient, the best approach is to just stay invested at all times. Because of this mentality, few investment managers will hold any significant cash. I believe this is a huge mistake and a disservice to clients. Cash is an asset class, just like stocks, bonds, real estate, etc. In fact, to me it’s the most important asset class because it offers the most flexibility. When I raise cash, I not only reduce portfolio risk by reducing exposure to risk-based assets, but I gain the flexibility to reinvest that cash if and when the market declines.

Unlike a pure market-timing strategy, when I make a decision to buy or to sell, I never commit to any specific time period. In other words, when I sell positions — as I have just recently done because I believe the market to be overvalued and am concerned about economic conditions — I do not have a specific time frame in mind during which I will stay out of the market and then, when the time frame ends, will automatically buy back in. I could be out of the market a matter of weeks, or it could be six months or longer. The time it takes for the market to correct is meaningless to me. Time is not the issue.

Too often investors, again programmed by the investment industry, believe it is bad to be out of the market. They believe (wrongly) that somehow, if they are not always fully invested, that they are going to miss out on the big score. The reality is that, in many more cases, they are more likely to be in the market during a big decline and therefore suffer a significant loss.

By understanding the true meaning of market timing and by being more open to alternative investing strategies, including tactical trading and using cash as an asset class, I believe investors can improve performance and, most important, avoid significant losses. The investment industry is a lot like medicine in medieval times — people believed in bloodletting and a lot of other crazy remedies that today we know to be wrong.

We are still learning about investing, and the industry is evolving. My best advice is to not take anything as gospel. Think for yourself and question everything. You will be a more informed investors and will very likely experience better long-term performance as a result.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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