Timing the Financial Markets

Timing the Financial Markets

 

 

There has been some misunderstanding in the financial community about the use of the word “time” or “timing” in discussing this subject. Obviously, the fund manager can control shifts between common stocks and cash or fixed-dollar assets in an effort to judge the timing of general market movements, and any measure of the fund manager’s skill should reflect his skill in making such judgements. The fund manager, however, does not control the time at which funds are received or at which they must be disbursed, and the measure should not reflect this timing.

There is an easy way to make the measurement of the rate of return insensitive to the timing of receipts and disbursals. In the BAI report, this measure has the possibly confusing name, “time-weighted rate of return.” Although the name may be confusing, the principle is not. The time-weighted rate of return is logically equivalent to the rate of return on mutual fund shares which are bought and redeemed at net asset value per share. The investor who purchases shares in a mutual fund can measure the rate of return on his investment by knowing the price he paid, the value of payments received, and the price of the shares at the end of the period in question. He does not need to know the time or amount of new investments in the fund by other investors who bought shares or the time or amount of disbursals from the fund to shareowners who redeemed their shares. The individual investor’s rate of return is totally insensitive to those injections of capital into or withdrawals of capital from the fund.

It will not be surprising to any reader who has persisted to this point that the BAI report recommends that performance must take account not only of the rate of return on assets but also of the risk to which the investor has been subject. It is undesirable or unwise for all investors to subject themselves to the same degree of risk, and therefore not all investors should expect the same rate of return. The elderly widow whose primary objective is the protection of her assets from loss cannot expect as high a return as the more venturesome young physician whose primary objective is to maximize the value of his holdings 25 years in the future. If one knew only the rates of return on the widow’s and the physician’s respective portfolios, one would not be in a position to judge the skill with which their investment advisers had done their work.

 

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