I am a big-time advocate of market timing, I don’t just say that it always works. I say that it is always required for investors seeking to keep their risk profile constant over time. In my view, stock investors who fail to practice market timing are failing to exercise price discipline when buying stocks. That can’t be right.
Q2 2020 hedge fund letters, conferences and more
Does Market Timing Work?
Critics of mine often point to time-periods in which market timing produced lower returns than what would have been obtained with a Buy-and-Hold strategy as evidence that market timing doesn’t work. I certainly acknowledge that the point of stock investing is to obtain a good return on one’s money. So returns matter. But returns are not all that matter. If higher returns are obtained at the cost of taking on excessive amounts of risk, that’s a bad result. A strategy that produces those sorts of results is a bad strategy, in my assessment.
At this year's SALT New York conference, Jean Hynes, the CEO of Wellington Management, took to the stage to discuss the role of active management in today's investment environment. Hynes succeeded Brendan Swords as the CEO of Wellington at the end of June after nearly 30 years at the firm. Wellington is one of the Read More
The primary difference between Buy-and-Holders and Valuation-Informed Indexers is that Buy-and-Holders believe that stock investing risk is stable (because stocks are always priced rationally) while Valuation-Informed Indexers believe that stock investing risk is variable (it is greater when the CAPE value is high and lower when the CAPE value is low). If risk varies, as Robert Shiller’s Nobel-prize-winning research shows to be the case, investors seeking to keep their risk profile constant MUST engage in market timing. There is no other way that the job can be done.
But Buy-and-Holders often look to short-term results to assure themselves that their failure to engage in market timing has not done them harm. Shiller warned in July 1996 that stock prices were so high that investors who stuck with their high stock allocations would come to regret the choice within 10 years. In reality, prices did not fall hard until late 2008 and they recovered by late 2009 and have remained high until today. So many Buy-and-Holders believe that they have been proven right in their decision not to follow Shiller’s advice to lower their stock allocation in 1996.
I don’t see it. I understand the point being made. A stock investor who lowered his stock allocation by 30 percentage points in 1996 and kept it at that lower level until today would not have as large a portfolio today as his Buy-and-Hold friend who maintained the same high stock allocation through that entire time-period. The Buy-and-Holder would say that the Valuation-Informed Indexer had “missed out” on gains by going with a lower stock allocation for a time. But gains are not all that matter in stock investing. The idea is to earn as much in the way of gains as possible while taking on as little in the way of risk as possible. To look only at gains and to ignore risk is to analyze poorly.
The 4 Percent Rule
I often make the point that those who argue that the safe withdrawal rate is always the same number (Buy-and-Holders say that it is always 4 percent) are taking an approach to risk analysis that would be laughed at if employed in the consideration of other types of risk. It is true, of course, that a 4 percent withdrawal rate has always “worked” in the sense that retirees who employed it at any time in the history of the U.S. market would have not seen their retirement fail. The 4 percent rule “worked” in the sense that good-enough returns were obtained in all cases. However, it most certainly did not work in the sense that those returns were obtained by taking on an acceptable amount of risk.
There have only been a few occasions on which the CAPE value rose so high that a 4 percent withdrawal was a high-risk withdrawal. But those are the situations that retirees of recent years should have been looking at since valuations have been so high from 1996 forward. Someone who employed the 4 percent rule for a retirement beginning in January 2000 (when the CAPE value was 44, the highest on record) had only a 30 percent chance of seeing his retirement survive 30 years. That ain’t safe. We cannot yet say how that retirement will fare over the 30-year time-period typically examined in safe withdrawal rate analysis. But in my view we can already say that the 4 percent rule “failed” in that it caused the investor to construct a retirement plan that was wildly risky, presuming that stocks continued to perform in the future somewhat as they always have in the past.
No reasonable person would say that drunk driving had been proven safe because a person had driven drunk on four occasions and had lived to tell the tale. That’s what the Buy-and-Holders are doing when they assert that a 4 percent withdrawal is “100 percent safe” (this is the language used in one Buy-and-Hold study) because it barely survived in the four occasions in the history of the U.S. market in which valuations hit very high levels. A showing that a retirement survived a risky situation is not the same thing as showing the retirement was safe all along.
The Concepts Of Risk And Survival
The Buy-and-Holders confuse the concepts of risk and survival. They wrongly conclude that a retirement that survives was never at risk because of that fact.
An investor who elected to tune out Shiller’s counsel in 1996 and to stick with a high stock allocation has not yet paid a price for doing so. But the history of U.S. stock prices shows that the day will come when he will do so. And that investor has already paid the price of taking on more risk than he intended to take on when he chose his stock allocation at a time when stock prices were not as out of control as they were in 1996 and in most of the years thereafter.
People draw the wrong conclusion when they take on excessive risk and avoid paying a price for a time and conclude that risk just doesn’t matter. In the long run, risk matters. In the long run, there is always a price to be paid for taking on too much of it.
Rob’s bio is here.