The Buy-and-Holders tell us all the time that market timing doesn’t work. I can’t even estimate how many times I’ve heard that one because the number is so high. The normal human reaction in response to hearing something repeated so many times is to believe that it must be true. It’s not. It’s not true.
There’s one form of timing that really doesn’t work. If you think that you can guess when a price change is going to take place and profit from those guesses, I am with the Buy-and-Holders in saying that it cannot be done. No one knows when price changes will come. When prices are high, they will be coming down in time. But it’s entirely possible that prices will go higher still before coming down. And they could remain high for a long stretch of time. It’s not possible to identify the time at which price changes will take place.
But that’s not the only possible form of market timing. What if you change your stock allocation not because you believe that you know when a price change will come but just because you appreciate that there is more risk associated with owning stocks when prices are high and you want to keep your risk profile roughly constant over time? The historical record shows that this form of market timing always works. It can take a long time. But the patient investor can indeed profit from engaging in this form of risk management. Crazy prices can remain in effect for a long time but the benefits of keeping your risk profile constant more than cover the downside in the long-term.
I’ve been arguing for valuation-based timing for many years. I have run into a good number of people who have shown great enthusiasm for the idea. I have also run into a good number who hate the idea with a passion. Most investors are in the middle. They don’t hate the idea as much as the fanatical Buy-and-Holders. But they don’t like the idea much either. The no-market-timing injunction has won their loyalty. The idea that market timing doesn’t work makes sense to them and they intend to stick with that belief until they see a good reason for questioning it.
In the event that stocks continue to perform in the future somewhat as they have always performed in the past, they will experience a good reason in the not-too-distant future. Prices like those that apply today do not last forever. They are not supported by the economic realities but only by investor emotion. When investor emotion shifts, it usually shifts suddenly and dramatically. Investors can experience in a few months losses of wealth that it took them many years to accumulate. To come to appreciate the need for market timing by living through a price crash is the hard way to learn that lesson.
The widespread resistance to market timing that I have encountered makes me wonder why so many investors have such negative views about it. My intuitive thought is that market timing makes all the sense in the world. Market timing is price discipline. All markets rely on market participants exercising price discipline to keep the market functioning. All that investors who practice valuation-based market timing are doing is acting on a belief that stocks offer a better long-term value proposition when they are priced well than they do when they are not priced well. Is that not a perfectly reasonable belief?
My sense of things is that most investors feel intimidated by stock investing. Their hopes for a decent retirement are at stake and so they don’t want to make mistakes. So they put a lot of trust in what experts say about the subject. The majority of experts say that market timing is a mistake. So most investors go with that.
Why do the experts say it?
My sense is that the idea that market timing is not required is part of the package of ideas that we think of as the Buy-and-Hold Model for understanding how stock investing works. Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns had not yet been published at the time the Buy-and-Hold Model was being developed. So the people who developed Buy-and-Hold had to take a shot in the dark on the question of market timing. They knew that the guessing-game approach did not work. So they assumed that no form of market timing was required. Once they went public with this belief, it became the accepted belief and over time it became a dogma that they do not like to hear challenged.
It isn’t so. Now that we know that valuations affect long-term returns, we know (if we dare to question the dogma) that valuation-based timing works. In a world in which valuations affect long-term returns, it is a logical impossibility that it would not. But the cement has hardened. I challenge you to find a Buy-and-Holder who possesses an open mind on the question. I haven’t come across many.
I wish that there the idea that market timing is not required or does not work was rooted in research. If it were, we could examine the research and point out whatever flaws there were in it that caused the Buy-and-Holders to reach their unfortunate conclusion. But there is no such research! Trying to refute the claim that market timing doesn’t work is like fighting with a ghost. Since the belief is based on nothing, there is nothing that can be argued to refute it.
It is based on the Efficient Market Theory! Some call it (more properly) the Efficient Market Hypothesis. That’s where it comes from. The Efficient Market Theory is an economic construct that posits that investors are engaged in the rational pursuit of their self-interest. If that were so, there could never be an overvaluation or undervaluation. So of course there would be no need for investors to resort to market timing to correct for either. Market timing would serve no purpose and would produce no profit in such a world.
But Shiller discredited the Efficient Market Theory! We need to move on. The thought that market timing might not work or might not be required was never based on anything substantial. It was just a theory and the theory never survived a research-based test. The first person to test the theory was Shiller and he showed that it does not apply. Market timing works just fine.
