Recent weeks have brought a chorus of warnings that markets may be entering bubble territory. Commentators, including John Hussman and Harry Dent, have both warned of a pending crash, while strategists at UBS have identified six out of eight bubble warning signs. (1, 2, 3)
Such warnings inevitably prompt the same tantalising question: if we can spot bubbles forming, surely we can profit from this knowledge? New research by Robert Jarrow from Cornell University and Simon Kwok from the University of Sydney, titled Riding a Bubble: A Study of Market-Timing Trading Strategies, suggests it might be possible to time bubble peaks and exits. (4) But before investors get carried away by this seductive notion, they should consider the overwhelming body of evidence showing that market timing, even during bubbles, remains one of investing's most dangerous temptations.
THE UNCOMFORTABLE TRUTH ABOUT MARKET TIMING
The evidence against successful market timing is both extensive and damning. Research by Javier Estrada examining 15 international markets revealed that missing just the ten best trading days resulted in portfolios 50.8% less valuable than passive investments. (5) These crucial days represent less than 0.1% of all trading days, making the odds of successfully capturing them vanishingly small.
Studies by Zhang & Wong (2018) and Dichtl et al. (2014) demonstrate that successful market timing requires prediction accuracy levels that are rarely achievable in practice. (6, 7) As Burton Malkiel notes in the latest edition of A Random Walk Down Wall Street, the average mutual fund investor earns returns roughly five percentage points lower than market averages due to poor timing decisions.
PROFESSIONAL ADVISERS FARE LITTLE BETTER
A comprehensive analysis of professional market timing strategies provides particularly sobering evidence. Henriksson's 1984 study found no evidence of timing ability amongst mutual fund managers, whilst Timmermann and Blake (2000) documented small negative returns when timing was controlled by public information. (8,9)
If well-funded institutions with teams of analysts, sophisticated models, and vast databases cannot consistently time markets, what hope do individual investors have? Even among hedge funds (supposedly the most sophisticated professional investors), only about 11% of managers achieve significant alpha, with top performers managing Sharpe ratios around 0.20 and annual outperformance of 4-5.5%. Crucially, this skill appears limited to specific market conditions and cannot be easily replicated through passive strategies.
The behavioural trap
The psychological forces that drive bubbles are the same ones that make timing them so treacherous. Daniel Kahneman and Amos Tversky's research on prospect theory reveals that humans suffer from systematic biases that sabotage market timing attempts.
Loss aversion leads investors to hold losing positions too long while selling winners too early. Overconfidence bias makes us believe we can predict the unpredictable. During bubble periods, any investment that becomes widespread conversation typically proves hazardous to wealth – a pattern that held true for Japanese real estate in the late 1980s, internet stocks in the late 1990s, and housing in the mid-2000s.
When prices fall sharply, the brain's amygdala floods our bloodstream with stress hormones, triggering an overwhelming urge to sell. Conversely, rising prices activate the nucleus accumbens, creating an irresistible desire to buy just as danger peaks.
The jarrow-kwok mirage
Against this backdrop, the Jarrow-Kwok research appears to offer a mathematical solution to market timing's psychological pitfalls. (10) Their "Q-bubble" framework uses options data to identify when prices exceed fundamental values, theoretically allowing investors to "ride the bubble" with predetermined exit strategies.
The researchers report impressive results, with their composite strategy earning 6.39% annually compared to 4.86% for buy-and-hold over their sample period from 1996 to 2023. However, several factors should temper enthusiasm for these results.
First, the strategy requires continuous monitoring of complex mathematical models and sophisticated options data analysis, far beyond the capabilities of ordinary investors. The research assumes institutional trading costs of 0.5% per transaction, whilst individual investors typically face much higher fees that would erode returns significantly.
More fundamentally, the strategy demands precisely the kind of disciplined selling that behavioural finance research shows humans are incapable of executing. The approach requires selling at predetermined levels even when prices appear destined to rise further, exactly when greed makes holding most tempting.
the hedge fund reality check
The professional investment world provides a sobering perspective on timing strategies. Research by Yang et al. examining hedge fund performance found that whilst these funds historically generated positive alpha, they no longer do so on average. (11) This decline reflects increased competition and the difficulty of maintaining edge as markets become more efficient.
Research specifically examining professional market timing reveals that timing ability is strongest only in volatile, bear, or low-liquidity environments – precisely when emotional pressures on investors are most intense. Even then, successful timing appears concentrated among a small subset of highly skilled, non-replicable managers. Attempts to systematically replicate hedge fund timing skill using passive funds have generally proven unsuccessful.
the danger of missing the best days
Perhaps the most compelling argument against market timing comes from research on the concentration of market returns. Estrada's analysis found that crucial trading days — those that drive the bulk of long-term returns — represent less than 0.1% of all trading days. (12)
This creates an impossible challenge for market timers. They must predict both when markets will fall (to avoid losses) and when they will rise (to capture gains). Missing even a handful of the best days can devastate long-term performance, yet these days are impossible to predict in advance. The best and worst days often cluster together during periods of high volatility, meaning investors attempting to avoid losses frequently miss the subsequent recovery.
the evidence for staying invested
While timing strategies promise superior returns, the evidence overwhelmingly favours a different approach. González Pozo's research (2021) supports immediate investment regardless of market outlook over attempts to time entry points. (13)
This reflects a fundamental truth about markets: they rise more often than they fall. Over the long term, the probability of positive returns increases with the holding period, making time in the market more valuable than timing the market.
the path forward
As bubble warnings multiply and market valuations stretch, investors face familiar temptations. The Jarrow-Kwok research offers sophisticated mathematical arguments for why timing might work this time. (14) But professional investment research shows that even the most skilled managers struggle with consistent timing success.
Rather than searching for timing strategies, investors should focus on what they can control: keeping costs low, maintaining diversification, and staying invested through inevitable volatility. These fundamentals lack the intellectual appeal of bubble-riding models, but they offer something far more valuable: the probability of long-term success.
For most investors, the best strategy remains breathtakingly simple: buy globally diversified index funds, invest regularly, and ignore the noise. It may not generate academic papers or media attention, but it works.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is an author and freelance journalist and is the Editor of The Evidence-Based Investor.
references
- https://www.hussmanfunds.com/category/comment/
- https://www.foxbusiness.com/media/trumps-post-election-market-boom-wont-stop-inevitable-doom-economist-harry-dent-warns
- https://preservegold.com/research/ubs-identifies-8-stock-market-bubble-warning-signs-six-have-already-appeared/
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4742890
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1082687
- https://doi.org/10.1016/j.physa.2017.12.049
- https://doi.org/10.1111/fire.12038
- https://doi.org/10.1111/j.1540-6261.1984.tb03897.x
- https://doi.org/10.1016/S0378-4266(99)00086-1
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4742890
- https://doi.org/10.1016/j.jeconom.2022.12.010
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1082687
- https://doi.org/10.1108/JFMPC-08-2020-0162
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4742890
