Yesterday, Rob of A Rich Life wrote a guest post on Money and Such, arguing the case for long term stock market timing. In effect he argues that when stocks are over valued wise investors should reduce their exposure to that asset class.
Boiled down to their essence, Rob's arguments are based on the assumption of regression to the mean. Regression to the mean is the assumption that given a large enough sample, things tend to average out. Yes, there maybe someone out there who is 7'3", but it is unreasonable to expect the next guy in your sample to be a giant as well. Similarly, the argument goes, if in a given period of time stocks dramatically over perform or under perform, you can expect that over the long term results will shift in the opposite direction such that the average matches to long term trends. A reasonable enough conclusion, and very much in line with common sense.
So where does this argument break down? Well, first of all, I am not sure that it does. Having said this, there seems to be plenty of empirical evidence to suggest that this common sense argument does not translate well into the real world. Here is a good one: take for example so-called balanced funds that have the freedom to follow Rob's proposed strategy by re-allocating investments between different asset classes. I have seen no evidence that these outperform the market over the long term. These fund managers are well paid and the whole idea behind their full time jobs is that they can identify inflection points in the market and shift asset allocation to take advantage of such changes. They are free to follow long term market timing, so why don't they? Or maybe they think that they are doing exactly that but are simply not successful? I don't know the answer, but this should raise some skepticism.
The trick, as always, seems to be understanding where the inflection points in the market are, or as Rob would put it, understanding when the market is overpriced. Rob's entire strategy seems to rely on his ability to understand when the market is overpriced, and to do so before others detect the same problem and the market self-corrects. If he can suggest a convincing strategy for achieving this goal, there may be something to his arguments. However, I tend to be skeptical of theories that are built on the assumption that everyone else is subject to mass delusion, hypnosis or hysteria, yet we seem to be the only ones retaining our sanity and keeping our wits. It just doesn't feel right.
I will make one more point that is completely irrelevant to the current discussion, but that is important in the context of evaluating evidence. One of the statements Rob made in his recent guest post did not sit right with me:
"Given that the studies are silent, I believe that we should default to our common-sense take that timing MUST work".
That line of reasoning does not pass muster. It boils down to: "the other side doesn't have proof, so our position wins by default". Hmmm. That doesn't work. You don't get to claim victory because the other side does not have proof. You have an equal burden of proof. In fact, if you are trying to go against accepted theory, the burden of proof is mostly yours to bear. You know the saying "extraordinary claims require extraordinary evidence". I am sure that Rob did not mean to use the statement in this fashion, but I wanted to make sure that the ground rules are clear.
While we are talking about investing, here are a few more posts on the subject from other PF bloggers:
My First Million recommends selling your energy stocks... now that sounds like short term market timing to me. He is certainly an aggressive trader. Rob and I are both Index guys. Right Rob?
The Sun's Financial Diary (actually it's a guest writer) is preaching real estate investing. Yeah, I think REITs are good for 5% to 10% of your portfolio, but going gangbusters on the stuff seems like a really bad idea.
Finally, Five Cent Nickel (or is it Fivecentnickel) reviews a new peer-to-peer lending site. You know, I have been meaning to look into p2p lending, but never seem to get around to it. It just seems like a lot of work, for a considerable level of risk and a bit more return. I think the idea has merit in principle, but I think may not quite ready for prime time.
Enjoyed this post? Please consider subscribing to Money and Such by free RSS Feed or by email. You can also follow me on Twitter.