The downturn of international stock markets in recent years has left many investors worried
about their portfolio performance and confused about the correct approach to portfolio
management. Research by Massimo Guidolin and Allan Timmermann demonstrates that
the ideal strategy depends on your investment horizon: a short-term view suggests ‘riding the
bull’ while a long-term view suggests ‘hunting the bear’. But whatever the choice, the
researchers stress the value of professional advice
Many are the rules of thumbs that have been made popular by investment advisers: ‘Go longer
in stocks the longer is the time left to retirement’; ‘Buy low and sell high’, ‘Chase the market
momentum’ (that is, buy on rising prices), etc.
This research, published in the Economic Journal, shows that these rules make sense as part
of a more complex strategy that carefully considers the underlying properties of the security
returns. None of these investment mottos are correct in isolation, but each of them should be
appropriately deployed as a reaction to current market conditions.
Research has shown that returns of a variety of risky securities – including popular stock
indices – should be described by models that characterise markets as going through a
sequence of bull and bear spells. In a bull market, security prices increase, while in a bear
market, they stagnate or drop.
Confronted with markets that swing between bull and bear phases, investors may feel
pressured to take a stand: either buy risky securities in bear markets and sell in bull conditions
(‘hunt the bear’) or the opposite, increase the commitment to equities during bull markets and
cash positions during bears (‘ride the bull’).
Another issue relates to the age of investors: does it help to buy stocks when young and
gradually to sell them when approaching retirement?
This study considers a risk-averse investor who is choosing between an investment in a UK
stock index (FTSE All Shares) and one in cash (Treasury bills). The investment horizon
determines whether it is optimal to ride the bull or hunt the bear. An investor with a short
horizon should buy stocks in bull markets and sell them in bear markets, thus chasing general
trends. A myopic horizon prevents her from successfully acting as a contrarian, taking
advantage of excesses.
In contrast, an investor with a long horizon should keep her commitment to stocks high in bear
markets and reduce it in bull markets. The long horizon allows her to take positions that
become gradually profitable as markets move from bear to bull and vice versa.
The research shows that the idea of going longer in stocks the longer the horizon is incorrect.
Such a strategy will work only in bear states, when it is important to accumulate strategic
positions that become valuable over time. In bull markets, investors should discount in their
current choices possible downturns.
For example, based on 1970-2000 estimates, an investor facing a bear market should have
invested only 6% in the FTSE index if her horizon was one month, 19% with an horizon of two
years, and 32% with 10 years. The behaviour of markets in 2001-2 would have handsomely
rewarded the choice to stay 81% long in Treasury bills.
Interestingly, these findings are receiving confirmation in other research by the authors in
which alternative classes of securities (for example, long-term bonds or US stocks) and
different preferences are admitted. Some of these results are coming as a surprise in the
academic research on optimal portfolio rules. Ignoring bull and bears, many recent studies
have reached strong conclusions on what investors ought to do, while it seems that more
sophisticated models of the dynamics of security returns imply that the portfolio choice problem
is more complex than previously thought.
How important are these findings for an average household? In a quantitative sense, the study
suggests that they might be significant: for example, an investor with a 10-year horizon who
regularly re-examines her portfolio structure every month should be ready to make a one-time
payment of 4% of her wealth to receive updated information on the probability of bull and bear
states. Such a figure is rather large when compared to standard fees applied by mutual funds.
In a qualitative sense, the study stresses that a clear strategic framework that maps
investment horizon, risk aversion and the frequency with which a portfolio is revised into
optimal decisions is crucial. The complexity of the task makes it likely that economies of scale
in learning how to hunt bears and ride bulls may exist. When based on appropriate models,
professional advice may deliver a 4% premium. Households should not trust themselves being
out in the market on their own facing wild beasts.
ENDS
Notes for editors: ‘Economic Implications of Bull and Bear Regimes in UK Stock Returns’ by
Massimo Guidolin and Allan Timmermann is published in the January 2005 issue of the
Economic Journal.
Guidolin is at the University of Virginia, Dept. of Economics, 118 Rouss Hall, Charlottesville,
VA 22903; Timmermann is at the University of California, San Diego, Dept. of Economics,
9500 Gilman Drive, La Jolla, CA 92093-0508.
For further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com).