Robert Shiller published research showing that market timing is required. It’s not often stated that way, In fact, I have never heard anyone other than me state it that way. The way that it is usually stated is that Shiller published research showing that valuations affect long-term returns. But isn’t that the same thing?
If different valuation levels translate into different long-term returns, the value proposition associated with the purchase of stocks is not constant but variable. It follows that investors should be changing their stock allocation in response to big valuation shifts. An investor who determined that a 60 percent stock allocation made sense for someone with his financial goals and risk tolerance would not want to maintain that same stock allocation when stocks offered a diminished value proposition. Perhaps he would switch to a 50 percent stock allocation in an effort to keep his risk tolerance stable. That would of course be market timing.
Q2 2022 hedge fund letters, conferences and more
Market Timing Is Required
So market timing is required. Those who follow the peer-reviewed research have known this for 41 years (Shiller published his research showing that valuations affect long-term returns in 1981). So why do claims that market timing always works and is always required inspire controversy (trust me – they do)? These are obviously true claims.
I would like to come to a clear understanding of why it is that people who work in this field are so reluctant to acknowledge the efficacy of market timing. We need to solve that puzzle if we are ever to get to a place where Shiller’s amazing research findings influence how every investor on the planet goes about buying stocks. Our misguided notions about market timing are holding us back. I believe that those misguided notions are rooted in the unfortunate way in which our knowledge of how stock investing works has grown over time. If we were starting fresh today, we would all be market timers and that would be good. But we developed some serious doubts about the merits of market timing at a time when we did not have Shiller’s research available to us and we have remained highly hesitant to reconsider those doubts during the 41 years in which it has been.
Is there a case to be made against market timing? That is the question that I am asking. If we all could agree that there is no case (that’s what I believe), then we should not have any trouble making market timing central to our stock investing routine. But there clearly is a case in the minds of the vast majority of investors. We need to identify it so that we can make the counter argument and convert all Buy-and-Holders into Valuation-Informed Indexers.
The strongest case is that market timing is a guessing game. You often hear Buy-and-Holders observe that a market timer needs to get both the date on which he lowers his stock allocation and the date on which he increases it again correct and that that is very hard to do. The good thing about this case is that it is entirely true. Short-term timing, the form of timing in which the investor seeks to identify a good exit point and a good re-entry point, really is a bad idea, according to the evidence that I have seen. So the Buy-and-Holders are right about that one. Short-term timing really does not work.
But….
Short-term market timing is obviously not the only form of market timing available to the stock investor. If Shiller is right that valuations affect long-term returns, then keeping one’s risk profile constant over time REQUIRES market timing. There are no guessing games required for investors using market timing for this purpose. The risk-management benefits kick in on the day the stock allocation is lowered and continue to apply regardless of how long it takes for stock prices to fall. It is possible that an investor who engages in timing for the purpose of risk management could see lower returns than his Buy-and-Hold friends. But he would be obtaining those lower returns at reduced risk; he would be maintaining the risk profile that he determined was right for him when he adopted his initial stock allocation. On a risk-adjusted basis, the long-term market timer always obtains superior results to the Buy-and-Holder.
So what’s the problem?
People's Perception
I think that the problem is that, in pre-Shiller days, there were no index funds. To invest in stocks meant to invest in individual stocks. With individual stocks, it is best to make a choice and then stick with it for a long time, for all the reasons that have been put forward by Warren Buffett for many years now. Timing became associated in the public mind with flightiness and flightiness is indeed something that stock investors should try to avoid. So market timing came to be perceived in the public mind as something bad, something foolish.
The rules that apply for the purchase of individual stocks simply do not apply for the purchase of index funds or for the management of a portfolio of individual stocks diversified enough to generate a performance similar to that generated by the market as a whole. The valuation levels associated with individual companies do not tell us whether those companies are good buys or not. Low valuations often apply for entirely good reasons. That is not so in the case of the market as a whole. When looking at the market as a whole, low valuations translate into good buying opportunities and high valuations translate into poor buying opportunities.
We didn’t know this in pre-Shiller days. So we got into the habit of thinking of market timing as something bad. There is precisely zero evidence in the research that market timing is something bad (I am not talking about the guessing-game version of market timing, which indeed is a bad idea). Market timing engaged in for the purpose of keeping one’s risk profile constant is always good and always works. All investors should be engaging in it at all times.
Even prior to Shiller, there was no research showing that market timing doesn’t work (there was no research showing that it always does work in those days but of course we have that now). How do we forget the lessons that we thought we learned in pre-Shiller days that have now been revealed to be false and dangerous ideas?
Rob’s bio is here.
