If Market Timing Works At All, It Works All of the Time

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If Market Timing Works At All, It Works All of the Time
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Does market timing work? That’s the only point of dispute between Buy-and-Holders and Valuation-Informed Indexers, advocates of the model for understanding how stock investing works rooted in the Nobel-prize-winning research of Robert Shiller.

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Buy-and-Holders' Beliefs vs Valuation-Informed Indexers' Beliefs

Buy-and-Holders believe that market timing does not work because investors act rationally, making choices aimed at advancing their self-interest. If that were so, the market could never be overpriced, risk would be constant and market timing would be impossible. In contrast, Valuation-Informed Indexers believe that investors are at times highly emotional and risk varies depending on how much irrational exuberance is present in the market price at a given time. If that is so, long-term returns are predictable (because the stock price always moves in the direction of the fair-value price) and market timing diminishes risk while enhancing returns.

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Most investors don’t get too worked up about the dispute. I have seen people get very excited in support of Valuation-Informed Indexing and I have seen people get very excited in opposition to Valuation-Informed Indexing. So it would not be right to say that most people do not care. But most investors do not feel an urgent need to see the dispute resolved. Many more are on the Buy-and-Hold side than there are on the Valuation-Informed Indexing side. And even those on the Valuation-Informed Indexing side are generally okay with watching how things play out over time to gain a better sense of which side has a stronger case.

I don’t believe that most investors appreciate the far-reaching implications of Shiller’s research. If Shiller is right (I believe he is), his work changes our understanding of how stock investing works in a fundamental way.

If irrational exuberance is a real thing, market timing isn’t just a good idea, it is absolutely critical. Market timing is the means by which stock investors practice price discipline. Price discipline is what makes markets work. If market timing is required for the market to function properly and most investors are persuaded not to engage in it, sooner or later the market will become dysfunctional and crash. Millions of retirements will fail, hundreds of thousands of businesses will go under and millions of workers will be thrown out of their jobs. If market timing is required, we should all be working together to encourage investors to practice it.

Market Timing Works, It Works All The Time

Market timing is not a hit-or-miss thing. If market timing works, it works all the time.

We encourage drivers to remain sober when they are behind the wheel. Driving sober is not just occasionally a good idea. It is of critical importance at all times. There is never a time when driving drunk is a good idea.

We encourage all people to eat carbs and sweets in moderation. Becoming obese is always a bad idea. Becoming obese increases the odds of a heart attack and a heart attack is a life-threatening event.

Say that we did not know that becoming obese leads to heart attacks or that driving drunk leads to car accidents. If that were the case, the state of the world’s knowledge of good eating habits and of good driving habits would be at the primitive level where its knowledge of good investing habits stands today. Since Shiller published his research discrediting the Efficient Market Hypothesis, those of us who have spent some time thinking the matter through carefully (about 10 percent of the population) know intellectually how important it is to practice market timing. But most of us either see the matter as being of no great import or actively disdain market timing (the Buy-and-Holders fall into this category).

Neglating The Downside Of A Failure

The problem is that we only see the downside of a failure to practice market timing when prices crash and retirements fail and businesses go under. That’s like only seeing the negatives of poor eating habits when someone experiences a heart attack or the negatives of drunk driving when someone is killed in a car accident. To overcome our bad investing habits, we need to be reminded of the downside of failing to engage in market timing each time we forget about the need to do so. It is through regular reiteration of the message that it becomes part of our basic understanding of what it means to invest effectively.

Why is market timing so critical? Because it is the means by which investors practice price discipline when buying stocks.

Why hasn’t it always been the conventional wisdom that market timing is essential? Because we didn’t always know all there is to know about how stock investing works, we once believed that investors were 100 percent rational, in which case market timing would not be required because overvaluation would be a logical impossibility.

Market timing works all the time. It doesn’t always quickly increase an investor’s returns. But it always gets his or her risk profile back to where it should be. Investors who go with the proper risk profile always end up with enhanced lifetime returns, just as people who eat carbs and sweets in moderation always enjoy healthier lives and just as sober drivers always live longer. The primary goal of investment advisors should be to get their clients so in the habit of engaging in market timing that they don’t even give serious thought to going with Buy-and-Hold strategies.

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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