Price discipline is the magic that makes all markets work. Buyers want low prices and sellers want high prices. Because buyers exercise price discipline when making purchases, sellers who demand excessively high prices are not able to complete transactions.
It is the exercise of price discipline that keeps things working. Sellers and buyers need to meet in the middle for markets to work. The exercise of price discipline on the part of buyers keeps things honest.
Achieve Price Discipline Through Market Timing
Except in the stock market. In the stock market, price discipline is achieved through the practice of market timing. Investors have a strong motivation to push stock prices too high because it is like getting a pay raise to see the value of their stock portfolio rise to levels not justified by the economic realities.
So long as buyers respond to high prices by selling some of their stocks, prices can never get too out of control. As with all other markets, price discipline is the key.
But we are told that price discipline/market timing is not really required when buying stocks. Investors who have gone with lower stock allocations when prices are sky high and with higher stock allocations when prices are at rock bottom lows have achieved better long-term results for as far back as we have records of stock prices.
So it would appear that the stock market operates according to the same general principles as every other market that has ever existed. Yet we are told that there might be circumstances in which market timing/price discipline might not work.
Why?
I sometimes wonder if it all might be just a marketing gimmick.
I wrote a book on saving strategies (Passion Saving: The Path to Plentiful Free Time and Soul-Satisfying Work) a number of years back. In that book, I argued that the often-heard rule-of-thumb that one should aim to save 10 percent of one’s income does more harm than good.
A 10-percent savings rate can be a good goal when one is young and not yet earning enough to save much more than that. But as income increases, many of us could save a great deal more than 10 percent if we thought through carefully what saving rate would be ideal for us given the benefits obtained from attaining financial independence early in life.
The thought that saving 10 percent is good causes a lot of us to not even consider saving rates far higher than that.
It’s not a terribly difficult concept to understand. I’ve known lots of people who saved much more than 10 percent and who say that it changed their life when they realized that achieving financial freedom early in life was an achievable dream.
Given how important it is to one’s enjoyment of life to achieve financial freedom as early in life as possible, why don’t we encourage everyone to work the numbers for himself or herself instead of relying on a terribly simplistic rule of thumb?
Applying The Rule Of Thumb
I believe that a big part of the explanation is that there are marketing benefits to employing a rule of thumb. People don’t need to take their individual circumstances into consideration when applying the rule of thumb. So the same advice can be given to every potential saver.
Just put aside 10 percent of your after-tax income and you are doing a good job, people are told. People hear the message and it sounds good to them. People who save a bit more than 10 percent are made to feel virtuous for exceeding the widely-advised saving goal.
I believe that something along those lines might be a factor in the widely-voiced admonitions against market timing. Market timing is a wonderful thing. It permits an investor both to greatly increase his lifetime stock return while also greatly diminishing the risk he takes on by investing in stocks.
That’s investor heaven! But most investors are afraid to even consider the benefits of market timing given how often they have heard that it is not really necessary or that it might not even work.
Market timing always works. But there are complications. It only works in the long-term (there really is evidence that efforts at short-term timing are just guessing games). And engaging in market timing often means swimming against the tide.
An investor who lowers his stock allocation because prices have risen so high that stocks no longer offer enough benefits to justify the risks attached to owning them may well find that prices continue to rise after he does so (it is investor irrationality that causes high stock prices and it is entirely possible that most investors will respond to the high prices they created with even more irrationality).
The market timer can feel strong pressures to return to his high stock allocation at just the wrong time for doing so.
Dubious Marketing Case
Market timing is a great strategy for achieving superior long-term results. But the marketing case for it is at times dubious. Could that be the reason why so many of the experts in this field are reluctant to endorse it?
I believe that there are other factors at play. The efficient market theory was in vogue in the days when the Buy-and-Hold strategy (no market timing!) was being developed. I think that played a big role in the decision to urge investors to think of “time” as a four-letter word.
Shiller discredited the efficient market theory with his Nobel-prize-winning research showing that valuations affect long-term returns. But by the time that research was published (1981), so many experts had devoted so many words to discouraging market timing that there was a good bit of institutional pressure in place in support of sticking with the original story.
The longer the old story remains generally unchallenged, the harder it becomes for those who want to be perceived as experts to acknowledge that they got it terribly wrong back in the 1960s.
So I do not believe that the opposition to market timing was entirely caused by the marketing downside of telling the full story. But I believe that those considerations in all likelihood were a contributing factor.
Rob’s bio is here.
