C a s e 7.4 Many investment managers employ a strategy called market timing, according to which they

C a s e 7.4

Many investment managers employ a strategy
called market timing, according to which they forecast the direction of the
overall share market and adjust their investment holdings accordingly. A study
conducted by Sharpe provides insight into how accurate a manager’s forecasts
must be in order to make a market-timing strategy worthwhile. Consider the case
of a manager who, at the beginning of each year, either invests all funds in
shares for the entire year (if a good year is forecast) or places all funds in
cash equivalents for the entire year (if a bad year is forecast). A good
»

C a s e 7.4

Many investment managers employ a strategy
called market timing, according to which they forecast the direction of the
overall share market and adjust their investment holdings accordingly. A study
conducted by Sharpe provides insight into how accurate a manager’s forecasts
must be in order to make a market-timing strategy worthwhile. Consider the case
of a manager who, at the beginning of each year, either invests all funds in
shares for the entire year (if a good year is forecast) or places all funds in
cash equivalents for the entire year (if a bad year is forecast). A good year
is defined as one in which the rate of return on shares is higher than the rate
of return on cash equivalents (as represented by Treasury bills). A bad year is
one that is not good. For Australia, the average annual returns for the period
from 1963 to 2008 on shares and on cash equivalents, both for good years and
for bad years, are shown in the following table. Sixteen of the 46 years from
1963 to 2008 were good years.

a Suppose that a manager decides to remain
fully invested in the share market at all times rather than employing market
timing. What annual rate of return can this manager expect?

b Suppose that a market timer accurately
predicts a good year 80% of the time and accurately predicts a bad year 80% of
the time. What is the probability that this manager will predict a good year?
What annual rate of return can this manager expect?

c What is the expected rate of return for a
manager who has perfect foresight?

d Consider a market timer who has no
predictive ability whatsoever, but who recognises that a good year will occur
two-thirds of the time. Following Sharpe’s description, imagine this manager
‘throwing a die every year, then predicting a good year if numbers 1–4 turn up,
and a bad year if number 5 or 6 turns up’. What is the probability that this
manager will make a correct prediction in any given year? What annual rate of
return can this manager expect?

»