By Wei Dai, head of investment research at Dimensional Fund Advisors
It is well known that asset allocation makes a huge contribution to total return, often dominating a portfolio’s performance. Around this time of year, many investors look to rebalance their asset allocation, hoping to take advantage of whatever big swing in asset prices occurs in the coming period.
As a researcher, I construct hundreds of strategies and test each one using decades of real market data to see which have been most successful. With all that data, finding one strategy that worked in a backtest is not a difficult task.
In our latest study on timing the market, we found 30 timing strategies that delivered reliable outperformance relative to staying invested in the premiums – the buy-and-hold strategy.
The best-performing strategy among those 30 was designed to time the market premium by dipping in and out of the equity market, switching between stocks and Treasury bills. Thanks to the decision to sit on Treasury bills during market downturns in 2001, 2008, and 2022, the strategy outperformed the buy-and-hold market portfolio by an annualized 5.5% from 2001 to 2022. That’s an average 5.5% on top of the market return for more than 20 years.
Before getting too excited, let’s take a closer look at how this best-performing timing strategy works. It uses the valuation ratio to time the market premium in developed ex US markets. At the end of each calendar year, the strategy compares the current price-to-book ratio of the market with its historical distribution over the most recent rolling 10-year period.
When the price-to-book ratio exceeds the top 20th percentile of its historical distribution, the strategy gets out of the market and invests in one-month Treasury bills. When the price-to-book ratio drops below the 50th percentile of its historical distribution, the strategy switches back to the market portfolio.
To achieve that impressive outperformance, how important is it to use this exact combination of parameters? Well, as it turns out, quite important. Tweaking a single parameter of the strategy, such as the rebalance frequency or the breakpoint, would reduce the excess return by more than half, making it no longer reliable.
The problem for anyone making asset allocation decisions – in fact almost all investment strategy decisions – is that information about the past is of only limited use when considering the future.
If you ask a large enough number of people to repeatedly flip a coin, someone will flip 10 heads in a row just by chance. If we try enough parameter combinations in our backtests, we should expect some strategies to generate outstanding results just by chance.
To generate our results, we had 720 people flipping coins (or 720 strategies) and the vast majority of these timing strategies underperformed. And this is before considering any trading and tax costs.
When we look at the big picture, it is clear the odds of successfully timing the equity premiums aren’t good and hindsight should only serve to remind us that past returns are not an indicator of future results.
The lesson from these backtests is not that one should adopt one of the winning timing strategies, but that winning timing strategies are fragile constructions made as much from a series of chance events than from reliable and repeatable factors.
What we can learn from this is that to improve the odds of capturing premiums over the long run, it is time to stop timing the premiums. Like any asset allocation decisions, they are loaded with idiosyncratic risk that rarely pays off and are often an expensive mistake for most people that attempt it.