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Investors Don’t Need To Change Their Stock Allocation Every Year But They Need To Consider The Possibility Every Year

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I am a big believer in market timing. That wasn’t always so. In earlier days, I was a Buy-and-Holder. But then I got into a very, very, very intense but also very, very, very silly controversy over whether it is possible to calculate the safe withdrawal rate accurately without taking the valuation level that applies on the day the retirement begins into account.

If Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns is legitimate research (I believe that it is), then that of course is impossible. If valuations affect the result, then valuations need to be considered.

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The Buy-and-Hold Model

Over time I came to question the entire Buy-and-Hold Model. What Shiller really showed is that stock investing risk is not constant but variable. If the market were efficient, as it was widely believed to be in the days when the Buy-and-Hold Model was being constructed, prices would always be at least roughly right (because rational investors would want stock prices to reflect the economic realities).

But, if irrational exuberance is a thing, it is clearly a very bad thing. If swings in investor emotion drive stock price changes, all stock investors need to be practicing market timing in an effort to keep their risk profile constant over time.

So I am no longer a Buy-and-Holder and am very much an advocate of market timing. But how strong of an advocate? How important is it that investors practice market timing? How often should they do so? How far should they go in their stock allocation adjustments? It has taken me years to consider all the possibilities and to gain at least a tentative fix on these questions.

I certainly don’t favor aggressive allocation shifts. Long-term timing always works. So I believe that all investors should be engaged in market timing. But short-term timing never works. We can say with virtual certainty that very high prices are eventually going to come down hard and that very low prices are eventually going to come up hard.

But we can say almost nothing about when the turning points in prices are going to come. They must come eventually because it is the core purpose of any market to get prices right and sooner or later the stock market is going to achieve its core purpose.

But we cannot say when prices are going to turn because it takes a change in investor psychology for it to happen and we do not today know enough about human psychology to identify when those turns will take place. The record of stock price predictors is very poor (although long-term predictions have held up well for the entire history of the market).

Adjusting Stock Allocation

So I don’t think that investors should make big bets on a belief that stock prices will be dropping in the future. We can say that stocks are more dangerous when they are priced as they are today than they would be if they were properly priced.

But taking a big bet on a price drop would be a mistake because it is entirely possible that the price drop will not come for some time.

The historical record of stock prices suggests that the investor who would be going with a stock allocation of 60 percent when stocks were fairly priced should be going with a 90 percent stock allocation when prices are at rock-bottom lows and with a 30 percent stock allocation when prices are at scary highs. Allocation changes of more than 30 percentage points are of dubious strategic value.

It is not necessary to make those 30 percentage point allocation changes at all often. If you go through the historical record of stock price changes, you will see that on average an allocation change is required only about once every ten years. Investor psychology does not change in a dramatic way all that often.

So we all should be practicing market timing and we all should be making only occasional stock allocation shifts. Market timing is a strategy that pays enormous long-term benefits but that works best when practiced in moderation.

That said, I believe that we all should be thinking about market timing much more frequently than once every ten years. To engage in market timing goes against human nature.

We all have a Get Rich Quick/Buy-and-Hold impulse residing within us. We want to believe that it’s possible to get something for nothing in the stock market and our brains go to work overtime trying to rationalize the unjustified irrational exuberance gains that we do experience.

Dangerous Level Of CAPE Value

An investor who has been enjoying irrational exuberance gains for a good number of years is going to find it very hard indeed to conclude on a day when the market crosses a dangerous CAPE threshold that he needs to cut back on his ownership of stocks.

Investors come to think of the gains they see in their stock portfolio as a measure of their intelligence and courage as human beings. There is a great reluctance to acknowledging that a large portion of those gains are phony.

To practice market timing effectively, we only need to make allocation changes occasionally. But we need to think like market timers always. When the CAPE value rises from its fair-value level of 17 to the only slightly dangerous level of 20, there is no need to make an allocation change.

Stocks are a bit more risky when the CAPE value is 20 than they are when the CAPE value is 17. But it is entirely possible that the CAPE value will dance between those two numbers for some time.

The downside of failing to practice market timing when the CAPE hits 20 is small and there is a penalty attached to practicing market timing too frequently (the asset class into which one moves the stock money is likely going to provide a smaller return than the average stock return.)

But the investor who opts not to lower his stock allocation when the CAPE hits 20 is going to feel tempted not to lower his stock allocation again when the CAPE hits 25. That could prove to be a serious mistake.

And the investor who opts not to lower his stock allocation when the CAPE hits 25 is going to feel tempted not to lower his stock allocation again when the CAPE hits 30 and then again when it hits 35 and then again when it hits 40. That is likely to prove to be an outright catastrophic mistake.

If you do not lower your stock allocation when the CAPE hits 20, you should at least be reflecting on the reality that a portion of your recent gains were not generated by economic realities but only by an irrational exuberance that will be disappearing from the scene in not too long a time.

High CAPE values are temporary CAPE values. You don’t need to practice market timing frequently. But you want to be in a mindset that appreciates the importance of market timing at all times.

Rob’s bio is here.