The idea is simple – move your investments between equities, bonds and cash as and when the different asset classes rise and fall. James Norton explains more.

However, the reality of this is not so easy. Research conducted by the Nobel laureate Robert Merton looked at what an investor would earn if invested in equities in rising markets and Treasury Bills (the US equivalent of gilts) when they performed more strongly.

He looked at the period 1927 to 1978 and concluded that $1,000 invested in Treasury Bills at the start of the period would be worth £3,600 by the end and $1,000 in equities would be worth $67,500. However, if someone had the ability to predict the market and invest in equities in the months that the stock market out performed Treasury Bills and vice versa, at the end of the 52 year period they would have been worth $5.36 billion.

With such a big prize at stake it is not surprising that so many “investment professionals” claim to be able time markets, but the reality is that this simply cannot be achieved. No one has even come close to this degree of success. It is very rare to find a money manger who can beat the market for more than 3-4 years in a row.

The reason for this is due to the closely related concepts of market efficiency, and the idea of the “random walk”. The logic of the random walk is that if the flow of information is unimpeded, and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable. As a result, prices fully reflect known information and even uninformed investors buying a diversified portfolio will obtain a rate of return that matches that of the experts.

In his famous book A Random Walk Down Wall Street published in 1973, Burton Malkiel said that a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. Malkiel later clarified this to say that the advice was not literally to throw darts, but to buy the whole market through an index fund!

The table below, compiled by Fidelity Investments, shows the annual percentage returns if an investor keeps his funds permanently invested, and what happens when the best 10 days and 40 days in every year are missed. The message is that it is very easy to get it wrong.

Annualised total returns 31st December 1987 – 2002. Source: Fidelity Investments. Past performance is not a guide to the future.

It is striking to note that if the ten best days were missed in the All-Share in the period 1987 - 2002, then investment returns would have been reduced by almost 33% and if the 40 best days were missed then the gains would be almost wiped out. The chance of investing at the right time is so slim that it is not worth trying.

This is why Evolve Financial Planning uses a buy and hold strategy. This provides us with the market return, and also ensures that trading commissions are significantly reduced and taxes can be reduced or deferred by buying and selling less often and holding longer.

However, this is not the end of the story. We also use a technique called “rebalancing”. Put simply this means that on an annual basis we will reset clients’ portfolios back to their agreed asset allocation. So for example, over the last three years, equities on the whole have performed very strongly and bonds less well. This means that we have been taking profits on equity holdings and increasing bond holdings. Such a simple strategy forces us to do what so many market timers attempt – we sell high and buy low. We are unlikely to be fortunate enough to sell at the top, or buy at the bottom, but this strategy ensures that over the long run this approach will work.

Rebalancing requires self control and does not allow investors to be greedy. It has been hard for some to accept that we should have reduced equity exposure over the last few months, but over time it must be our job to ensure that clients are taking the risk they signed up to. Those who successfully rebalanced their portfolios during the tech boom escaped the worst of the fall out and have prospered in the subsequent market rally.

About the Author: James Norton (pictured) ACA, FSI, APFS, CFP, is a Director at Evolve Financial Planning. Evolve Financial Planning are winners of the Scottish Widows Award for IFA newcomer 2006, and are writing a series of articles exclusively for FinanceDaily.co.uk on the subject of investing. Evolve are also the first financial planning firm in the UK to be awarded Chartered status from the Visit www.evolvefp.com.

The Archive

Exchange Traded Funds: Financial adviser and investment expert James Norton explains all about Exchange Traded Funds.

The Benefits of Index Funds: Users of index funds are often accused by active managers of missing out on huge potential returns, but James Norton of has yet to come across anyone who can persuade him otherwise.

Your Investment Portfolio: Fixed Interest: Gilts, corporate bonds and other fixed interest investments are often overlooked as ’boring’ when it comes to building an investment portfolio, but, as James Norton argues, sensible investing is not about excitement.

Investing: Active versus Tracker Funds: The second article in our series on investing looks at the argument of active versus tracker funds and highlights evidence which suggests that most fund managers - so called stock choosing experts - invariably make the wrong stock selection choices.

Why Invest?: Financial planner and former stock-broker, James Norton, sets out how you can construct highly efficient, cost effective portfolios which should outperform many highly active managers.

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