When reasoning to support an argument goes astray.

It’s always refreshing to see articles appear proclaiming that active management works. One of the more recent was from The Wall Street Journal (8/21/14) by Spencer Jakab, titled, “Yes, Virginia, You Can Time the Market.”

Jakab took a very simple approach using the Shiller P/E ratio to underweight or overweight stocks by 30% when the ratio was in the top or bottom 10th of readings and by 20% if it was in the next two. The result: a 68% improvement in performance over a buy-and-hold portfolio.

Unfortunately, it seems a lot more common to find articles proclaiming market timing doesn’t work. Typically, market timing is used to refer to any action an investor might take to reduce risk in uncertain markets. To help advisors explain to clients the common logical flaws in the “there’s nothing you can do … suck it up and hold on” passive investing arguments, some of the more common fallacies are explained below.

Myth #1: Missing the best market days leads to underperformance

It typically runs like this: The market makes most of its gains in a very few great days. If you miss those days, your portfolio is going to dramatically underperform. This seems to make perfect sense. If you do nothing more than miss the very best days of the market, you are going to underperform. Besides being statistically impossible, why would an active management strategy be designed to miss only the best days? Ideally, it should miss the worst days—and if the manager is reasonably successful at that, the potential for smoothing returns is well worth the effort.

One landmark academic study of the “miss the best or worst” argument was conducted by University of Michigan finance professor H. Nejat Seyhun for Towneley Capital Management back in 1994. The Towneley study showed that investing $1 on a buy-and-hold basis in a value-weighted index of the NYSE, AMEX, and NASDAQ stocks would have returned $637.30 from 1926 to 1993. A perfect market timer would have ended the period with $690,000,000. Reality check: This is also statistically impossible, and no one has demonstrated that level of accuracy; but the difference in total return shows the value of attempting to do so.

A more contemporary study along the same “miss the best days-miss the worst” approach confirms the benefit of missing the worst days, but also looks at what happens if you miss both the best and the worst. The analysis by Hepburn Capital Management concluded in part, “The best days tend to closely follow the worst days. Sometimes they occur back to back. So if an investor misses one, chances are he will miss the other, as well.” If an investor missed both the 10, 20, and 40 best and worst days, the resulting average returns exceed that of the S&P 500 Index for the 25-year period ending December 31, 2013, according to the study.

Myth #2: Trying to beat the S&P 500 is futile

The statement that 90% of mutual fund managers fail to outperform the S&P 500 is often tossed around to validate an index fund as the best investment. Rob Isbitts, founder and chief investment strategist of Sungarden Investment Research LLC, ran a study to test the accuracy of the statement and found there were no time periods in which the S&P 500 outperformed 90% of mutual funds. “The index was a middle-of-the-road performer in most of the 24 separate time period/peer group combinations studied. There is a noticeable tendency for the index to perform better than its active peers during friendlier market environments. During the two bull periods, the index outperformed 80% and 63% of its peers. However, during the down market cycles (bear), the index beat only 34% and 38% of its active management competitors.”

Myth #3: Averaging gains and losses disproves active management

Like Jakab, money manager Tobias Carlisle used Robert Shiller’s cyclically-adjusted price-to-earnings ratio as a timing trigger for Kenneth French’s value portfolio, backtesting the portfolio from 1926 through mid-2014. But instead of overweighting or underweighting the portfolio, Carlisle made 100% moves using two scenarios: (1) when the portfolio was one standard deviation and (2) two standard deviations above or below the average P/E. Then he calculated average annual returns and proclaimed a nail driven into the coffin of active management when those results came in below a buy-and-hold portfolio.

But averaging gains and losses is a far cry from actual performance. It doesn’t take a 30% gain to make up a 30% loss—it takes a 43% gain. A 50% loss takes a 100% gain. Averages overlook the reality of gains and losses. When you look at the benefit of minimizing losses, the buy-and-hold portfolio underperforms.

Myth #4: Time frames for backtesting are not cherry-picked

Investors generally don’t have 88-, 75-, or even 50-year investment time frames. If they start early, they may have 30 to 40 years of significant investing before retirement. A backtest using 20-, 25-, or 30-year time frames is going to produce different results than a 75-year backtest. It is also interesting to see how many studies “proving active management doesn’t work” conveniently fail to include bear markets at the start or the end of the study period.

With that said, active management is not necessarily a tool for the average investor. To succeed, a strategic active investment management approach must be systematic, disciplined, and non-emotional. The investor or fund manager must understand the system sufficiently to have confidence in its signals and the ability to execute those signals in a cost-effective, process-driven manner. Without an effective system and discipline, one runs the risk of emotional buying and selling—all too often at the worst possible point in the market cycle. In knowledgeable hands, however, active management can be a powerful tool for achieving improved risk-adjusted returns.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.