<FOOLISH FOUR PORTFOLIO>

How to Time the Market
And asset allocation for Fools

by Ann Coleman (TMF [email protected])

Alexandria, VA (January 5, 1999) -- Market timing is a real bugaboo around here. Want to insult someone at Fool HQ? Call him/her a market-timer. Today I turn market timer and asset allocation specialist.

Last month I declined to offer advice on asset allocation, suggesting that an individual is the best judge of his or her own situation, but the topic just won't go away. OK. Let's do it!

First, remember asset allocation is based on market timing, and market timing, as traditionally defined, is something no one I know of has been able to do consistently. OK, back up. What's market timing? (I was reading the Fool for a couple of years before I really figured that out. All I knew was that Fools didn't like it much.)

Market timing is the idea that one can buy or sell or "shift assets" BEFORE the market makes some kind of move in order to profit by that move. For example, if you think that the market is going to "correct" (i.e., drop like a rock), you would sell your stock before that happens.

When it works, it works great. Let's look at Spiders, or Standard & Poor's Depositary Receipts <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %>. You can buy and hold SPDRs and know that you will equal the market return. Now, say last summer you had a feeling that things were about to go south, so you sold all your SPDRs around the end of July, then, after the market bounced around a bit and seemed unlikely to drop much more, you bought them all back in October. Instead of a measly 28% return on your investment, you would have had a return somewhere around 60%. Click here to see how that works: SPY one year chart.

That's why market timing is so darn popular.

In retrospect, it is so easy to see how much money you could have made if you had just known then what you know now. Of course, if you were off by a bit.... Say you expected the peak of the market to be in March (as many people did), and you sold then only to buy back in July because, obviously, you were wrong about the market turning down... then you could have actually managed to lose money last year investing in SPDRs.

Asset allocation (as usually practiced) assumes that it is possible to predict the market, but not very well. It's a "hedge your bets" approach to market timing. Instead of selling everything in a panic, the asset allocation model suggest that you shift some of your stocks into bonds when, in the opinion of the asset allocator, the market is in danger of correcting. Or the allocation model might suggest moving some of your bond money into cash in case interest rates go up.

The problem is that most market timers are not right often enough to beat a buy-and-hold (or Foolish Four) strategy over the long term. (Please don't send me "proof" that your favorite market timer can beat the market unless you have at least a 10-year history. Over the past 10 years, the Foolish Four [RP version] has returned a compounded average of 23% per year. If you can beat that with market timing and can prove that the model is based only on factors that are both consistent and knowable in advance of the moves, I would love to see the proof, and I will report on it here in this space.)

A huge industry has grown up to advise people on when to shift their money from stocks to bonds to cash, but the returns for these strategies haven't beaten the Foolish Four. In fact, most haven't even beaten the market.

If asked, the purveyors of these schemes solemnly tell you that your "risk adjusted" returns are higher. But what buys the bigger boat -- a 12% risk adjusted return, or a 20% non-risk adjusted return?

Before you decide that I am out of my mind, let me say that of course, you should "hedge your bets." The Foolish way to do that is not by trying to determine what the market might do next month or next year, but by a completely different kind of "timing."

Instead of timing the market, you "time" your assets. Ask yourself when you will need this money. Saving to buy a house three years from now? Stick that money someplace safe. Saving for retirement 10 or more years down the road? Well, consider this: even going all the way back to the miserable '60s, the Foolish Four has never had a 10-year period where it returned less than 8% compounded annually. You have to go back to the 1970s to find a 10-year period where the return was less than 20% per year. Those are good odds.

So here is how to Time the Market. Money you won't need for at least 10 years should be in stocks. Money you won't need for 5-10 years can be in stocks if you are comfortable with the increased risk. Money you will need in the next 5 years should be in cash or a money market fund, because if you look at three-year or one-year time periods, stocks can scare you into subscribing to a market timing newsletter!

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

01/05/99 Close

Stock Change Last -------------------- CAT - 1/8 47.25 JPM + 3/16 107.38 MMM + 7/16 75.06 IP + 11/16 42.81

Day Month Year FOOL-4 +0.49% 1.53% 1.53% DJIA +1.38% 1.41% 1.41% S&P 500 +1.36% 1.26% 1.26% NASDAQ +1.96% 2.67% 2.67% Rec'd # Security In At Now Change 12/24/98 24 Caterpilla 43.08 47.25 9.68% 12/24/98 14 3M 73.57 75.06 2.03% 12/24/98 9 JP Morgan 105.51 107.38 1.77% 12/24/98 22 Int'l Pape 43.55 42.81 -1.69% Rec'd # Security In At Value Change 12/24/98 24 Caterpilla 1034.00 1134.00 $100.00 12/24/98 14 3M 1030.00 1050.88 $20.88 12/24/98 9 JP Morgan 949.62 966.38 $16.76 12/24/98 22 Int'l Pape 958.12 941.88 -$16.25 Cash $28.26 TOTAL $4121.39 </FOOLISH FOUR PORTFOLIO>