I believe in market timing. Not the short-term variety, where you try to guess where stock prices will be six months or twelve months out. I don’t believe in that form of market timing even a little bit. But I strongly believe in long-term market timing, where you determine the likely 10-year annualized return on stocks given the current CAPE value and adjust your asset allocation to keep your risk profile constant over time.
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Most people don’t share my enthusiasm for the concept. I thought it might help to list six changes in one’s thinking about how stock investing works that one must go through to develop a strong affinity for the market timing concept.
Distinguishing Short-Term Timing From Long-Term Timing
One, you must distinguish short-term timing from long-term timing. All of the bad things that are said about market timing apply to short-term timing, none of them apply to long-term timing. To conclude that market timing is not worth doing because there is one approach to it that doesn’t work is like concluding that, because driving drunk is dangerous, no one should ever get behind the wheel of a car.
Two, it is important to understand WHY short-term timing and long-term timing are so different. The reason why long-term timing always works is that the market’s core job is to get prices right; that is what markets do. So, when stock prices travel far from their fair-value level, you can be virtually certain that they will be moving hard in the direction of the fair-value price over the next 10 years or so. So why doesn’t short-term timing work as well? In the short term, stock prices are determined by investor emotion. Investor emotion is unpredictable. There is just no telling what stock prices are going to do over the next year or so.
Three, there is no need to pick turning points in the market for market timing to work. If you change your stock allocation in response to a big shift in stock valuations, the move pays off on the day you make it. The price of course may not move in the direction in which you are ultimately expecting it to move. But your purpose in changing your stock allocation is to get your risk profile where you believe it should be. Your risk profile changes immediately. If you always get your risk profile right, you will see a benefit over time. It’s not possible to say when and it is not necessary to say when for market timing to work. The important thing is to keep that risk profile on track.
Taking The Emotion Out Of Stock Investing
Four, the best thing about market timing is that it takes the emotion out of stock investing. Investors who do not engage in market timing are implicitly buying into an understanding of how stock investing works (the Buy-and-Hold Model) that posits that price changes are caused by economic developments. If that were so, price increases would be great news because they would suggest a more productive economy and price drops would be bad news because they would suggest a less productive economy. The investor following that model is inevitably cheered by price gains and depressed by price drops. The market timer, in contrast, believes that price changes are caused by shifts in inverter emotion that possess no economic significance. All price changes have both a positive component (price gains increase his portfolio size and price losses increase his expectations of future returns) and a negative component (price gains lower his expectations of future returns and price drops lower his portfolio size). So he is indifferent to price changes and does not get emotional in response to them.
Five, market timers understand that it is an investor’s lifetime return that matters, not the return that he obtains over any particular stretch of years. Many investors who are concerned about today’s high stock prices are reluctant to lower their stock allocation because they fear that they could not earn a good enough return investing in safer asset classes. What they fail to appreciate is that investors who minimize the setback they will experience during the next price crash thereby ensure that they will have more funds to invest in stocks at a time when they will be offering a much higher long-term return. When both the pre-crash and post-crash years are taken into consideration, the market timer does not “miss out” on anything.
Six, market timing is really just the exercise of price discipline. We all try to exercise price discipline when making purchases of all of the goods and services that we buy other than stocks. Shiller’s Nobel-prize-winning research shows that the stock market works in the same way as all those other markets -- price discipline is essential. Buy more stocks when prices are good and fewer stocks when prices are poor and you will end up ahead of the game in the end, possibly by hundreds of thousands of dollars. Things have been playing out that way for as far back as we have good records of stock prices. Price discipline matters. Market timing works.
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