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The Purpose Of Market Timing Is To Avoid Irrational Exuberance, Not To Outsmart The Market For Profit

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I love market timing. I believe that it is the key to long-term success in stock investing.

I of course understand that the vast majority of stock investors have very different beliefs about the subject. Buy-and-Holders believe that market timing is a mistake.

The great John Bogle (I mean that sincerely, not at all sarcastically) used to say that, not only did he not know anyone who had ever enjoyed success with market timing, he never even knew anyone who knew anyone who enjoyed success at market timing. This thing that I love so much has a bad rep among lots of very smart people.

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Why Investors Disdain Market Timing

There are two big reasons.

One is that people often fail to distinguish short-term market timing from long-term market timing. Short-term market timing is a guessing game. You have to first guess right as to when prices will move in one direction and then guess right again as to when they will move in the opposite direction.

Good luck with that one, you know? No, that doesn’t work. I am 100 percent with my Buy-and-Hold friends re short-term market timing.

But it’s hardly reasonable to rule out market timing in general because one foolish form of the practice rarely produces good results. Driving drunk is a terrible practice. We all know it. But few of us conclude that we need to give up driving as a result.

We distinguish the foolish approach to driving, which truly doesn’t work, from the reasonable approach to driving, which helps us to get to places we need to get to. So it should be with market timing.

Practicing long-term market timing permits us to maintain the same risk profile when stock valuations (and thus the long-term return offered by stocks) change. That always works. No one has been able to identify a time-period in U.S. history when it did not.

The second reason why most investors disdain market timing is that experts in this field have done a poor job of making the case for it. Shiller’s Nobel-prize-winning research showing that valuations affect long-term return shows that timing is required for investors seeking to maintain the same risk profile over time.

Since the value proposition of stocks changes with changes in valuation levels, timing is essential. Follow-up research that I co-authored with Wade Pfau shows that investors who are willing to engage in market timing can thereby reduce the risk of stock investing by as much as 70 percent. Market timing transforms the stock investing experience in a powerfully positive way.

But few investors see it that way today. The experts in this field started promoting the Buy-and-Hold strategy before Shiller’s research was available to us. In those days, the Efficient Market Theory was all the rage.

If the market were efficient, Buy-and-Hold really would be the ideal strategy and market timing really would not work. It is the magnetic pull in the direction of fair-value prices that makes market timing such a valuable tool.

Take away the possibility of overvaluation or undervaluation (the Efficient Market Theory posits that investors always make rational choices that serve their own interests and that thus mispricing is not possible) and market timing serves no purpose.

Shiller’s Research

The experts felt too embarrassed to acknowledge their error when Shiller’s research was published. So they ignored his work. It’s 50 times harder to acknowledge the error today, after it has been covered up for 41 years.

So today there is zero intellectual support for the idea that market timing is not required (without market timing, there is no means by which stock prices can return to fair-value levels other than a devastating price crash) but a mountain of institutional support for it.

So the experts spin things in a direction very different from the way in which they would need to spin them to reassure investors that market timing is the way to go. The idea has caught on that the purpose of market timing is to outsmart the market.

It is true in my assessment that the small number of investors who engage in timing are making better choices than the large number who fail to do so. But it is not because they are trying to do something super sophisticated.

They are merely doing what they are required to do to keep their risk profile constant over time. The false perception that market timing is a tricky business scares a lot of investors who are perfectly capable of pulling it off successfully away from market timing.

The purpose is to minimize the effect of irrational exuberance! Irrational exuberance is obviously a bad thing. When stocks are priced as they are today, the true and lasting value of the typical portfolio is not much more than half of its nominal value.

That makes it pretty darn hard to engage in effective financial planning. The market timer is aware of the disparity between nominal portfolio value and valuation-adjusted portfolio value. That’s why his stock investing efforts are so much more successful over the long term.

To do well with stocks, you need to have some idea of what is going on. Knowing the true value of your portfolio is pretty darn basic.

The Buy-and-Holders never know how they are doing because they are committed by the strategy they have chosen to follow to ignore irrational exuberance and to fail to engage in the market timing that common sense would compel them to engage in if they possessed a more advanced level of awareness of the realities.

Rob’s bio is here.