Market timing example

Old wisdom says that it is better to see once then read one thousand times. So lets see some little market timing example.

I used data from Shiller's irrational exuberance page. I created stock total return data index starting in 1871 together with cash index (which is based on 10 year goverment yield minus 2%). Now lets use simple rule which says:
1. Sell stocks and move to cash this month if stocks were under 10 month simple moving average previous month
2. Buy stocks this month if they were over 10 month simple moving average previous month

So I applied very strict rule -> we know signal at the end of previous month but we are selling or buying stocks during actual month. This brings some lag and decrese performance (compared to buy/sell at the end of the month we have received signal) but it is more realistic.

We could see, that our performance for market timing index is slightly worse then buy and hold. But it is little price compared to decrease in volatility and drawdown measures. So we were able to increase Sharpe ratio by nearly 50%.

We can also see on graphs that our drawdowns are smaller and equity line is smoother. So market timing money management tool really isn't tool to improve performance but is absolutely great in risk protection.

And how does it improve risk parameters? Simple moving average rule forces investor to exit market when it goes to periods of greater volatility. So it works like stop loss rule. Financial markets tend to be fat-tailed, downside volatility tend to cluster and stop loss rules protect investors from big negative tail events which have great impact on performance.