What About Market Timing to Reduce Investment Risk?

Sometimes it's just not productive to be in the market, so a common request is to find a way to time fund purchases as a way to either improve your overall returns, or at least to reduce the risk and volatility of your returns. The problem doing this with mutual funds is twofold:

1) It's very hard to actually time the market well,

2) The fund companies have made it more difficult. They have introduced Early Redemption Fees (ERF's) that make it difficult to get in and out of the market very often without either destroying your returns with their extra fees every time you switch, or they may just ban you for overtrading in their funds.

With that in mind we developed a simple calendar based system that improves the odds of getting better returns, and historically reduces volatility.

Seasonal Stock Market Trends

The most popular of the calendar based systems is explained by the adage "Sell in May and go away." Simply put, you stay out of the market for the 6 months beginning with May, and buy again in the beginning of October. And actually those 6 months do underperform. But exploring that a little deeper, you find that the 2 worst months of the year since 1950 have been August and September. Armed with that we looked at the performance of the Fidelity Equity system from January 1995 to January 2006. Specifically we looked at the performance during each of our quarterly holding periods.

The 3rd quarter (July thru September) underperformed on our system as well. The compounded return in that quarter was -1.1%, by far the worst. In addition, out of 8 negative quarterly returns, 4 of them were during the 3rd quarter, including the 3 worst quarters we had in the backtest (1998, 2001, 2002).

By going to cash in the 3rd quarter holding period, the overall return of the Fidelity Equity system improved slightly (just over 2%). However, the maximum drawdown improved from about 27% to 13%. While these are backtested results, it shows a significant improvement in the volatility of the system returns.

You can see more about this system at

http://fundztrader.com/fidelity_seasonal_fund.html

If you'd like to take a look a the monthly returns yourself, there's a novel little online calculator at

http://www.moneychimp.com/features/monthly_returns.htm

There are other forms of seasonality or calendar based trading as well. Over a longer cycle, there is the Presidential cycle. This tracks which year of the Presidential election cycle we are in, with the proposition that the year before a Presidential election and the election year itself outperform the other 2 years.

Over the short term, there is the month end and holiday seasonal bias. This was first popularized by Norm Fosback in his book Stock Market Logic in the 1970's. He noted that the last 3-4 days of each month along with the first 1-2 days outperform then rest of the month for most months. Hulbert's Financial digest still tracks this, and it continues to perform well after all these years. This bias is why we execute the trades for both the Fidelity and ETF systems after the 1st week of the month.

Next we will cover Market Timing options with ETF's.