Sunday, December 10, 2006

Market Timing vs. Sector Timing

In his book Investment Policy: How to Win the Loser's Game Charles Ellis compares two kinds of investment methods. One was perfect market timing while the other was perfect sector timing.

From 1940 to 1973, if you caught all the major market advances (he counted 11), and went to cash during the declines, you'd end up with 85 times your original money. Pretty good, you say, and you'd be right. That's about 14% a year, compounded.

But during the same period, if you were invested in the one best industry group (again, only counting major moves), and switched whenever another one became the best (about once a year), you would have an astounding 4.35 million times your original money! Your compounded return would be about 57% a year.

So right there, it seems that sector timing has quite an edge. It seems that for market timing to outperform it, the market timing needs some other extra advantage--like maybe using leverage (thus increasing risk), or making shorter-term trades (thus needing more attention, giving more chances for mistakes, and likely costing more in brokerage commissions).

This may explain why the sector timing advisory newsletters I see often perform better, in general, than the market timing services. Some use mutual funds (such as Fidelity sector funds) and others use exchange-traded funds (ETFs), but either way, it would seem from this study they have a leg up on services that just trade the broad market indexes.

Generally there is at least one industry sector going up, no matter what the general market is doing. For instance, from early 2000 to mid-2002, while the S&P 500 was losing nearly 30%, the Fidelity Select Home Finance Portfolio doubled in value.

The trick of course is to figure out which industry is going to do well. Obviously no one can do this perfectly, but maybe some can come "close enough" to make the effort worthwhile. If you know you're going to have mistakes whatever you do, you might as well start with basic parameters that put the odds more in your favor. So this line of reasoning tends to favor trading industry sectors instead of the broad market indexes.

Next time: Some sector advisories to check out.