Most of today’s stock investors follow some form of the Buy-and-Hold strategy. That is, they do not think of market timing as a good thing. They set a stock allocation and then stick with it as prices go up and down.
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Valuations Affect Long-Term Returns
I view that approach as highly dangerous. Shiller’s Nobel-prize-winning research shows that valuations affect long-term returns. If that is so, then the value proposition of stocks is not stable but variable. Investors who wish to keep their risk profile stable over time must be willing to engage in market timing to do so. It is by making adjustments to his stock profile in response to big valuation shifts that an investor stays the course in a meaningful way.
The fact that Shiller’s research findings have had so little practical impact in the 40 years since they were published is in a surface sense highly discouraging. I view Shiller as the most important investment adviser alive. But the proof is in the pudding. Given how few investors have changed their strategy in response to his research findings, I think that it would be fair to say that thus far Shiller has been a failure. His “revolutionary” (this is the word that Shiller uses in the subtitle to his book) ideas on how stock investing works should have helped us keep stock prices at reasonable levels. But there has never been a time in U.S. history when stock prices have remained at super high levels for as long as they have in the past 25 years.
Things are not quite as hopeless as they appear, in my assessment.
Buy-and-Holders Never Explored Other Possibilities
The strange reality is that most Buy-and-Holders follow the strategy not because they gave consideration to all of the possibilities and concluded that Buy-and-Hold is the strategy that makes the most sense. Most Buy-and-Holders have never explored other possibilities. Buy-and-Hold is their default option because most experts have endorsed it and they have never heard those expert views challenged.
Please note that I did not say that most investors have never heard the expert views effectively challenged. Most investors have never heard Buy-and-Hold challenged in any way. That means that, if in some future day, challenges are presented (I believe that this will happen in the days following the next price crash), people who are today following a Buy-and-Hold strategy may lose confidence in the strategy and shift to a Valuation-Informed Indexing strategy. It is much easier to convert people who never made an active choice to adopt the belief in which they currently have confidence.
There is one exception to this general reality. Investors have heard the case made for short-term market timing. People post arguments all the time about why they believe that stock prices will be moving up or down in the next six months or the next year. To the extent that investors have rejected those arguments (most have but certainly not all have), they have done so after hearing both sides of the story. I don’t believe that a price crash will cause too many investors to regret not following a short-term market timing strategy.
Long-Term Timing
The story is different with long-term market timing, however. Most investors reject long-term timing for flaws that apply only to short-term timing. For example, investors will say that it is difficult to pick both good entry points and exit points for their stock ownership. That’s of course true. But there is no need to identify good entry points or good exit points for a long-term timing strategy to be effective. The purpose of long-term timing is to keep one’s risk profile constant over time. The benefits of the strategy are immediate. All that an investor is doing when he lowers his stock allocation in response to a big price increase is shifting to the stock allocation that he determined at an earlier time was proper for someone with his financial goals and risk tolerance. The new allocation gives him what he wants (the proper stock allocation) regardless of how long it takes for prices to fall to their fair-value level.
Another concern that most non-market-timers have is that it is a bad idea to be out of stocks for too long. Again, that is of course true. But those who follow long-term timing strategies rarely see it as a good idea to be out of stocks altogether. Their aim is to keep their risk profile constant over time. So they might increase a 60 percent stock allocation to 90 percent stocks at a time when stock prices are insanely low and then lower it to 30 percent stocks at a time when prices are insanely high. That’s market timing and it is a strategy that provides the investor following it with huge benefits over the course of an investing lifetime. But it almost never requires the extreme step of getting out of stocks altogether.
Most Buy-and-Holders fail to make these distinctions between short-term timing and long-term timing. They have heard experts warn of the dangers of market timing, and finding the arguments against short-term timing persuasive, have sworn off market timing in general. But saying that the dangers of short-term timing are a good reason for not engaging in timing at all is like saying that the dangers of driving drunk are a good reason never to drive a car. The one thing just does not follow from the other. Many investors who are today suspicious of all forms of market timing will quickly see the appeal of long-term timing once the case for it is available to them. These investors have never in any deep sense rejected the idea of long-term market timing. They have allowed themselves to be cowed into not fully exploring the concept.
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