Jim Parker, a Regional Director from Dimensional Fund Advisors Australia, has posted another interesting piece on his Outside the Flags commentary made available to financial advisors who use Dimensional funds as a part of their recommended portfolios.

The commentary looks at the difficulty of predicting turning points in the market (timing) based on the economic cycle.

Regards,
Scott Keefer

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Safety first is the name of the game for many investors right now. And with wild day-to-day swings in the markets and hugely divergent performances by securities within the same asset class, who can blame them?

Tolerance for risk is at extremely low ebb, a development reflected in the fact that yields on risk-free assets are at historic lows?in the case of US Treasury bills at levels not seen since World War II.

Yet this risk-averse behaviour masks one of the paradoxes of investment.

In good economic times, when comfort levels are high, the expected return from risk assets is less favourable. In those times, the cost of our willingness to take a risk is a lower expected return.

Correspondingly, in tough economic times, when risk aversion rises, the expected return from risk assets goes up. In these times, the cost of our reluctance to take risks is not capturing the higher expected returns on offer.

So those now harbouring the bulk of their portfolios in Treasury bills, cash-like instruments or sovereign bonds are forgoing the opportunity to get the full benefit of the bounce in risk assets when it comes.

So why not wait till the economy recovers? The problem there is that the equity market tends to price in a turn in the cycle before it is evident. So by the time the news media proclaims an economic downturn to be over, the market usually has already accounted for it.

This is what financial economists mean when they say the market is a discounting mechanism. It absorbs new information very quickly. In other words, by the time you start worrying about it, it is already in the price.

The numbers back this up.  (Source: National Bureau of Economic Research for peak and trough months; Professor Kenneth R. French's website for market risk premiums.)  For instance the average monthly risk premium of the US equity market over T-bills from April 1960-December 2007 is 49 basis points. That's a 6 per cent annualised return over the risk free asset.

But now look what happens around the peak and trough of the economic cycle: In the three months after the peak of an expansion, the average equity risk premium has been -1.52 per cent. But in the three months after the trough of the cycle, the average risk premium was +1.87 per cent.

What this means is that the market tends to price in turning points in the economic cycle before these are confirmed. This explains the difficulty of successfully timing the market and reinforces the benefits of staying disciplined in your chosen asset allocation. (Bear in mind that turning points in the cycle are usually only identified 6-18 months after they occur.)

Inmoo Lee, 'Risk Premiums Across Business Cycles', Dimensional Fund Advisors

While the market volatility we have seen this year has been hard to take, this has to be set against the unusually low volatility of the preceding years. The experts also tell us that history suggests we can expect further volatility.

The good news is that periods of high volatility have no predictive power in relation to future returns. Neither is there any predictive power in periods of "high cross-sectional dispersion", when securities in a given asset class have very dissimilar performance in a given month. We are in such a period now.

It's also worth keeping in mind that when markets are so choppy and fickle, diversification is even more important. That's because the sort of volatility you would experience in a portfolio with just a few stocks during settled markets will be evident in a very well diversified portfolio in wildly variable markets.

So the lessons from all this are twofold: Firstly, diversification both across and within asset classes is always important, but even more so at times of instability. Secondly, during tough economic times, risk premiums rise to compensate investors. While volatility can be hard to stomach, there's no evidence that this is a leading indicator of future negative returns.