Market Timing Makes Stock Investing Rational

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Rationality is about making informed choices. You could just eat whatever you feel like eating. But, if you are rational, you consider the effect that what you eat will have on your long-term health. You don’t always choose the most healthy option.

The rational thing is to permit yourself some fun every now and again. But the rational thing is not to mindlessly choose fun every time. The rational thing is to make informed choices.

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Investors Are Irrational

Most of today’s stock investors do not invest rationally. It's because they have heard from proponents of the Buy-and-Hold strategy that there is no need to engage in market timing. An investor who does not even consider the effect that valuation levels have on long-term returns is not making informed allocation choices.

He is mindlessly going with the fun option of treating irrational exuberance gains as if they were every bit as real as economic-based gains. Price indifferent strategies remove rationality from the stock investing project.

Buy-and-Holders don’t like it that it is not possible to say precisely when the benefits of market timing will kick in. The CAPE value reached a dangerous “25” in 1996 and Robert Shiller published a paper telling stock investors that those who stuck with their high stock allocation would come to regret doing so within 10 years.

The reality is that prices did not collapse until 2008. There’s no way to know precisely when a price crash will arrive. And, even if return predictions going ten years out always worked, many investors don’t possess enough patience to wait that long for a timing strategy to pay off.

Most investors have time horizons extending out for six months or one year, perhaps two years. Ten years is pushing it and twelve years is just out of the question.

But the reality is that that is the best that we can do. There is a strong correlation between today’s CAPE level and the return that will be obtained from stocks over the next ten years. The correlation is even better at 15 years out and at 20 years out.

To ignore that reality when setting one’s stock allocation is irrational. It’s like eating a diet full of sweets and carbs. It’s fun. No one can stop you if that’s what you want to do. But science shows that there is a price to be paid for making that sort of choice. It’s not the rational way to go.

I look forward to living in a world in which rational stock investing is encouraged rather than discouraged. I believe that that world is coming in the days following the next economic crisis brought on by the relentless promotion of Buy-and-Hold strategies. There are all sorts of interesting questions that experts in this field will feel free to examine in those days.

The Merits Of Market Timing

Shiller’s 1996 prediction was off. It took 12 years for a price crash to arrive, not 10. If more research were done on the merits of market timing, we could have had a better sense of what the chances were of that happening.

Shiller suggested that the price crash would arrive within 10 years because that is the way things had always gone up until the day when he advanced his prediction. The problem is that we do not have enough of an historical record of stock prices to know all the possibilities.

As we spend more time researching these matters, we will get a better fix on these things. Perhaps Shiller could have said that there was an 80 percent chance that investors who stuck with their high stock allocations would come to regret doing so within 10 years and a 95 percent chance that they would regret doing so within 15 years.

The full reality is that it won’t even take 10 years for market timing strategies to pay off in a world in which investment experts feel free to point out the dangers of Buy-and-Hold.

Most people don’t want to invest in a way that serves their long-term interests any more than they want to eat in a way that serves their long-term interests. But many of us make sincere efforts to achieve a balanced diet because we have been educated as to the benefits of doing so.

There’s no reason to think that stock investors would not make the same effort to practice market timing effectively if only they were made aware of why it is so important to do so. When most investors are market timers, prices will correct much more quickly than they do today, when market timing is often discouraged.

Inefficient Markets

The market is not efficient. The thought that it was was a mistake (in fact, it was this mistake that led the Buy-and-Holders to believe that market timing is not necessary). But, if most of us faithfully practiced market timing, it seems likely that the market could achieve something close to complete efficiency.

Each unjustified price gain would cause knowledgeable investors to lower their stock allocation a bit (because the long-term value proposition of stocks is diminished each time the stock price moves farther away from its true-value level). Those sales would pull the stock price down until it reached its proper level.

Investors have a desire to invest rationally. I think the Buy-and-Holders were right about that one.

What they go wrong is in not appreciating that they possess a Get Rich Quick urge that pushes them to make poor choices and that they need solid guidance re market timing to get it right. It is the Buy-and-Hold mindset that is the cause of most irrational stock allocation choices.

Rob’s bio is here.