To Rule Out Market Timing Is To Rule Out Price Discipline When Buying Stocks

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To Rule Out Market Timing Is To Rule Out Price Discipline When Buying Stocks
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Valuation-Informed Indexing #404

By Rob Bennett

[REITs]

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price discipline
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If I were to say “I believe in market timing,” your reaction would probably be negative.

If I were to say “I believe in exercising price discipline when buying stocks,” your reaction would probably be positive.

The two things are the same thing!

There is a bad form of market timing, of course. When people hear the term “market timing,” they almost invariably think of the bad form — short-term market timing. Short-term market timing is where you take guesses as to where stock prices are headed over the next few months. I agree with the conventional view that short-term market timing rarely works, for all sorts of reasons.

But there is also a good form of market timing. That’s long-term market timing. Long-term market timing is where you change your stock allocation in response to big shifts in stock valuations with the understanding that you may not see benefits for doing so for as long as 10 years. It’s by engaging in long-term market timing that you exercise price discipline when buying stocks. This form of market timing always works and in fact is always required for investors seeking to keep their risk profile roughly constant over time.

Short-term market timing is bad because it is mostly just guesswork. You might say “oh, when stocks are priced too high, prices are likely to drop, so I will lower my stock allocation.” The test as to whether you are making a smart move or not is — Are you working under the belief that the price drop will come soon? Or do you understand that it could take a long time for the price drop to arrive?

If you are working under the belief that the price drop will come soon, there is lots of evidence that your chances of guessing right are poor. Stocks were overpriced in 1996. If you lowered your stock allocation at that time thinking that prices would be coming down soon, you were proven very wrong over the next four years. Stock prices more than doubled in that time frame.

But if you lowered your stock allocation at that time with an understanding that it could take a long time for the price drop to arrive, you have done fine. It was possible in those years to invest in low-risk asset classes (Certificates of Deposit in the early years, then IBonds and Treasury Inflation-Protected Securities) that offered returns of 3 percent real or even 4 percent real for as far out as you wanted to own them. Stocks have paid a return of only 3.2 percent real from January 2000 through today and stocks are priced today for a big price drop in the not too distant future. So you would have done a good thing by moving to a lower-risk asset class at a time when the high-risk asset class was priced to offer a poor long-term return.

The reality that short-term timing doesn’t work has been stressed so frequently and for such a long time that investors have come to believe that even long-term timing is either not necessary or not likely to be effective. Nothing could be further from the truth. For the entire history of the market, investors have been dramatically increasing their long-term return while also dramatically reducing their stock investing risk by practicing long-term timing. Long-term timing is the big exception to the general rule that there is no such thing as a free lunch.

Why does it work? Why is it so powerful a strategic choice?

Long-term timing is price discipline. Can you think of anything you can buy where it does not make a difference whether you exercise price discipline or not? If you go to a car dealership and tell the salesman that you just want to obtain a good car and you really do not care what price you pay, you are going to get a far less appealing deal than you would get if you exercised price discipline. So it goes when buying stocks as well. Exercise price discipline and you will be ahead of the 90 percent of investors who elect to follow Buy-and-Hold strategies instead. And of course we should not be surprised that that is the case. Price discipline is important to the functioning of markets. We should expect the payoff for exercising it to be large.

In a perfectly rational world, short-term timing would work too. If stocks are overvalued, it makes sense to go with a lower stock allocation. It should be a plus to do the sensible thing. The problem is that stock prices are determined primarily by shifts in investor emotion. Emotions are by definition not rational and thus they are unpredictable. At a time when prices as a rational matter should be going down, they can go up and up and up for a long time.

In the long term, however, the rational investor possesses a big edge. It is the very purpose of a market to get prices right. So sooner or later stock prices are going to head in the direction of the fair-value price. The more mispriced they are on the high side, the more certain you can be that future price swings will be in a downward direction. The more mispriced they are on the low side, the more certain you can be that future price swings will be in an upward direction. Long-term price movements are highly predictable. Going long-term takes the guesswork out of market timing.

We all spend more money on stocks in the course of a lifetime than we do on just about anything else we buy. We all should be sure to start obtaining the same benefits of exercising price discipline when buying stocks that we already obtain when buying cars and carrots and sweaters and suntan lotion. Price discipline is good stuff. Market timing works!

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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