Having a knack for market timing

AS INDIVIDUAL investors, you and I make lots of mistakes. We trade too much, hold on to losing stocks for too long, and buy stocks on the basis of just headline news. However, there is also a pool of investors who are known to outperform the market. Warren Buffet comes to mind. His investment skills have seen him become the second wealthiest man in the world.

While smart "stock picking" is one way to beat the market, an often less mentioned strategy is market timing. Timing is critical as the stock market is like a roller coaster ride with its peaks and troughs as we have witnessed in the global financial crisis 2007-08, and more recently in August with the effect of China's economy on stock markets worldwide.

Thus, just as important as knowing what stock to buy is knowing when to get in and out of the stock market. Market timing is a different investing strategy from stock picking since it requires knowledge of the whole market and macroeconomy, not just of a single company. Furthermore, since almost all information relevant to the macroeconomy is publicly available, it is hard to believe that some investors have better information than others. This implies that good market timers understand public information better than other investors.

Take the two market crashes in 2000 and 2008 as examples. Prior to these crashes were several years of high stock returns. The 2000 crash was precipitated by a thriving dotcom business. When the dotcom crash came, the US stock market felt the full effect with a loss of almost US$5 trillion. The 2008 crash was characterised by lending boom. The crash saw a global financial meltdown which, to this day, has left some places such as Europe still reeling. In the US alone, loss of about US$7 trillion in wealth was reported.

Given the highs and lows of stock markets, can market crashes be predicted? Are individual investors able to time their market participation to take advantage of bubbles and crashes?

My research of stock purchases for the 1995-2009 period, covering both the crashes, indicates that there is persistence in market timing ability. Individuals who timed the market successfully in the first half of that period were more likely to time successfully in the second half. That is, investors who successfully sold just before the 2000 crash were also more likely than others to sell just before the 2008 crash. Conversely, those who timed poorly around the 2000 crash also had more likely poor timing when it came to the 2008 crash.

Together, the findings suggest that since there are some investors who can time market correctly, it implies that there is some predictability in market returns. This means that the market cannot be perfectly informationally efficient.

Who are these investors who have a knack for market timing? Middle-aged investors are better timers than younger and older investors. On the other hand, young investors are the worst timers, suggesting that investors learn with experience as they age. However, past a certain age, timing performance dips because of decline in cognitive ability that comes with age. Men are just as likely to be the good timers as well as poor timers. They occupy both ends of the spectrum.

Unfortunately, the average individual investor cannot time the market well. Instead, the sophisticated ones who trade in options and invest in higher-than-average market risk securities are likely to be good timers. Good timers also have a more diversified portfolio, and they trade less.

Market timing and stock picking also appear to be distinctive skillsets. While the average investor may not be a skilled timer, it does not mean that he is also a poor stock picker. There is little evidence that stock picking and market timing skills are related.

As there is evidence that some investors can consistently time well and beat the market that way, we can therefore learn and improve such timing skills. This may involve trading in an experimental manner to learn or use financial products that do not make sense in a world characterised by efficient markets.

Finally, companies can also benefit by successfully timing the issue of their shares when prices are abnormally high, as well as time their share repurchases or the granting of executive stock options.