It’s a rare thing to see an article explaining how best to engage in market timing. Most of today’s investors either don’t believe that market timing is necessary or don’t even believe that it works. So the demand for such articles is weak. I hope that that soon changes.
Investors Should Practice Market Timing
I believe that market timing always works and is always required. I base that belief on the finding in Robert Shiller’s 1981 Nobel-prize-winning research showing that valuations affect long-term returns. If returns rise and fall with changes in valuation levels, then the risk associated with investing in stocks is not constant but variable.
It follows that an investor who wants to keep his risk profile constant over time (an investor who wants to Stay the Course in a meaningful way) must practice market timing (he must make changes to his stock allocation in response to price swings). How could it ever not work for an investor to keep his risk profile constant over time?
So market timing is needed. But how to do it? That’s a different question. It would be nice if every expert in this field wrote about that issue regularly. The research that I co-authored with Wade Pfau suggested that market timing is the biggest contributor to long-term stock investing success.
So it would be ideal if lots of viewpoints re how to go about it were available to all investors. Unfortunately, the Buy-and-Hold criticisms of the market timing concept have limited the material available to us. What if that changed? What could we learn?
One very basic question is how often should an investor engage in market timing. There isn’t much need for market timing when the CAPE level only moves a point or two. Stocks offer a powerful value proposition when the CAPE is 17 (the fair-value CAPE level) and stocks offer a powerful value proposition when the CAPE value is 19.
The value proposition is not nearly as strong when the CAPE value reaches 25 or surpasses it. Investors who are disinclined to practice market timing except when it is really needed should feel free to stick to the same stock allocation for long stretches of time.
Dramatic Changes In Valuation Levels
A review of the historical return data reveals that dramatic changes in valuation levels are not common. It’s not really necessary for an investor to change his stock allocation more than once every 10 years on average. It’s very important to make allocation shifts on occasion. But this is not something that you need to be thinking about on a daily or weekly or monthly or even yearly basis.
That said, it would be nice to see research offering suggestions for how often to time the market. And of course I would expect that not all researchers would come to precisely the same conclusion or that all experts reviewing the work of the researchers would offer the same spin on their results. I would like to see lots of smart people begin directing their energies to examining this matter.
Allocation Changes
Another question for which much more study is needed is the question of how significant the allocation changes should be. I do not believe in extreme allocation positions. I would have concerns about a 100 percent stock allocation even at times of very low stock valuations and I would have concerns about a 0 percent stock allocation even at times of very high stock valuations.
My usual suggestion is that investors go with 60 percent stocks at times of moderate valuations, 30 percent stocks at times of very high valuations and 90 percent stocks at times of very low valuations.
That’s a vague recommendation. Researchers could offer more precise guidance and investment advisers could offer analyses detailing the pros and cons of various approaches. Should investors seek to limit their allocation shifts? Or is the best policy to make one allocation shift each year, even if the change in the CAPE level is not large enough to justify a significant change?
I see this as an open question. When I first began examining these matters, my aim was to make as few allocation shifts as possible. I believe that my thinking was influenced by the Buy-and-Hold distaste for market timing. As I have become more comfortable in my belief that market timing is a good thing, I have come to believe that a plan calling for a larger number of small allocation shifts probably makes more theoretical sense.
The question that I would most like to see more research on is the size of the penalty suffered by investors who engage in market timing premised on a belief that stocks will continue to perform in the future somewhat as they always have in the past when that turns out not to be so.
Stock prices have remained higher for a longer time-period in recent years than they have at any earlier time in the history of the U.S. market. That suggests that market timing may not pay off as well for the investors of today as it has for investors in all earlier time-periods. To what extent is that likely to be so? We need more good minds looking at the issue to form a sound take re the likely answer to the question.
Another big matter is the question of where investors should put the money that they have taken out of stocks. Should they put it in safe asset classes like IBonds and Certificates of Deposit so that it can be easily moved back into stocks when the valuation picture improves?
Or does it make sense for investors to seek other equity classes for which valuation levels are more appealing? I find it shocking how little research is available on these sorts of questions 42 years after Shiller published his amazing research showing the need for it.
Rob’s bio is here.
