Open Forum: What is “Market Timing”?

I wanted to continue the discussion about “passive” vs “active” investing here with an important question for readers:

What is market timing?

A basic definition of market timing would be the attempt to predict the market’s future direction.  I’ve argued that there is no such thing as an investment approach that doesn’t construct a general foundation that has implicit market predictions.  For instance, a 60/40 stock/bond portfolio is a stock biased portfolio that makes an implicit bullish macroeconomic forecast.  That is, the performance of this portfolio is contingent on the performance of the underlying economy.  So, even if you don’t change the portfolio over time you are still making a bullish macro forecast.  That forecast just doesn’t change.

The reason I ask this is because the concept of “market timing” is an extremely vague one often used in the “passive” vs “active” debate.  If you accept my view that there is no such thing as truly passive investing then that means we’re all active to some degree and the key to portfolio construction is really all about finding the most efficient active approach that is consistent with our personal financial goals.  But even if that’s true then the concept of “market timing” still plays an important role in how we go about formulating an investment methodology because it will help us understand how to maximize the various efficiencies.

So, what is market timing in your opinion and where do we draw the ling between what is market timing and what isn’t?  Obviously, day trading and even picking stocks would be an approach I disagree with in general because they involve a degree of forecasting that seems largely unrealistic or just extremely difficult.  Is market timing really just a term to deter people from using short timeframes and specific strategies that are extremely difficult to implement?  For instance, the longer into the future we look the greater the probability of making accurate forecasts (ie, output will grow over time).  And the greater number of instruments we utilize the greater probability we have of being right (ie, diversify and you’re more likely to be right than you would be by picking a handful of stocks).  Is this all just a discussion about the optimal timing period?  Looking too far into the future is useless while looking too far into the present is unpredictable?  What is the right time period then?  And what is the right amount of diversification?  At what point do we diversify to the point that we’re actually hurting performance?

And what about asset allocation strategies that involve option writing on a monthly basis?  Or what about asset allocation strategies that hedge portfolios at times to create greater stability (for instance, a business that buys futures contracts on a related commodity)?  What about Risk Parity approaches and Smart Beta strategies?  Are they really that different from “passive investing” or is this all just different variations of active investing?  Where do we draw this line between what is “market timing” and what isn’t?  Or is the whole concept nebulous to begin with?  Are we really just worried about avoiding high fees and other actions that lead to inefficient portfolio construction while building a relatively long-term portfolio that is diversified in order to increase the probability of our implicit forecasts?

I should be clear – while I am obviously a macro investor I am not against the use of lazy portfolios or what is thought of as “passive” investing.  But I do wonder if the approach has been portrayed as something entirely different from “active” investing when in reality it’s just a generally more efficient version of it with a good deal of gray area between “active” and “passive” strategies.  I’d be interested in your thoughts.

Related:

• Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance
• Debunking some Common Investment Myths
• We Are All “Active” Investors
• Most Index Funds are Macro Funds
• Putting the “Underperformance” of Active Managers in Perspective
• Of Course 80% of Active Managers Underperform the Market!
• There’s no Such Thing as “Forecast Free” Investing
• The Importance of Understanding Your Implicit and Explicit Forecasts
• The Importance of Understanding Your General Portfolio Framework