This is a guest post from Rob of A Rich Life. If you would like to be a guest writer on Money and Such, shoot me an e-mail at shadox1 at the domain name gmail.com.
I wrote an earlier guest blog entry entitled “Passive Investing Is a Strategy for Extremists” that argued that investors should change their stock allocations in response to big shifts in valuations, going with higher-than-normal stock allocations when prices are low and going with lower-than-normal stock allocations when prices are high. Shadox expressed some skepticism in a critique of that blog entry, asking: “Why make the assumption that investors will be better at predicting the long-term peaks and troughs in the market than they are able to predict short-term ones?” This guest blog entry is my response to that question (Shadox and I agree that short-term market timing does not work).
At the top of the huge bull market that ended in January 2000, stocks were priced at three times fair value. That means that for every $300 you put into stocks, you obtained $100 worth of shares in U.S. business enterprises and $200 worth of cotton-candy nothingness. When you buy something that is overvalued, you overpay for the thing purchased. You pay more than that thing is worth. There is no reason to believe that you will obtain an investment return on the amount of the overpayment any more than there is a reason to believe that you obtain a better car than those who pay $20,000 when you pay $60,000 for a car with a fair market value of $20,000.
The average long-term stock return is a bit above 6 percent real. It is realistic to expect to see a return somewhere in that neighborhood. But not on the entire $300 you invested in stocks. You obtain the 6 percent real return only on the $100 that you invested in stocks, not on the $200 invested in nothingness. So your likely long-term return on the entire $300 payment is not something in the neighborhood of 6 percent, but something in the neighborhood of 2 percent. A 6 percent return on $100 is $6. A return of $6 on a payment of $300 is a percentage return of 2 percent.
That is why I believe that investors should be changing their stock allocations in response to big shifts in valuation levels. Common sense tells us that the long-term value proposition of investing in stocks must be better at times of low and moderate prices than it is at times of insanely dangerous prices (I will explain in a follow-up guest blog entry what valuation metric I use to determine when stock prices are “insanely dangerous”). We all consider risk and return when setting our stock allocations. Since our realistic assessments of risk and return must change with big changes in valuations, our stock allocations should change with big changes in valuations as well.
That’s the case for long-term market timing. Nothing fancy. It’s plain old common sense.
The reality, however, is that this common-sense argument is a highly controversial argument today. Millions of smart people, ordinary investors and experts both, strongly believe that market timing is impossible. Can it really be that millions of smart people have become convinced of something that defies common sense?
Yes, that is precisely what I believe to be the case. To understand how this strange state of affairs came to be, you need to consider how our knowledge of how stock investing works has developed over the years.
The common goal of stock investors in the days before the popularity of Passive Investing was to buy low and sell high. That’s market timing. The reason why we have long divided the community of investors into bulls and bears is that for a long time the name of the game was to anticipate in which direction stock prices were headed.
The Passive Investing Revolution brought an end to that for millions of investors and for most investing experts. The Passive Investing advocates told us that it was a mistake to act on the intuitive belief that stocks must offer a better deal at low or moderate prices than they do at sky-high prices. They didn’t put forward this claim as a matter of personal opinion. They backed it up with the hard stuff -- academic research SHOWING (not just claiming) that market timing doesn’t work.
There are indeed hundreds of well-executed studies showing that timing doesn’t work. It is not hard to understand why many became excited about these breakthrough findings. It is not hard to understand why many became convinced that the best way to invest is not to guess which way prices are headed but to determine the proper stock allocation and then stick with it for the long run.
It turns out that those studies were misinterpreted. I mentioned that there are hundreds of studies showing that timing doesn’t work. Do you know how many of those studies examine whether long-term timing works or not? The answer is -- not one of them. All of the studies showing that timing doesn’t work examine short-term timing; they look at whether changing one’s stock allocation in response to price changes pays off in six months or a year or perhaps two years. These studies are silent on the question of whether long-term timing works (long-term timing is changing your stock allocation in response to big price changes with the understanding that you may not see benefits for doing so for five or perhaps even ten years).
Given that the studies are silent, I believe that we should default to our common-sense take that timing MUST work (for the reasons explained at the top of the blog entry). But we don’t need to base our belief in long-term timing in common sense. There are studies that look into the question of whether long-term timing works (Robert Shiller, author of the book “Irrational Exuberance” is the lead researcher in this area). Do you know what these studies say? They say that long-term timing works. It has always worked. There are no exceptions in the historical record.
Common sense tells us that timing should work. And the research on long-term timing backs up what common sense tells us. The puzzle is not why long-term timing works; common sense explains that. The puzzle is -- why DOESN'T short-term timing work? How can it be that so many well-executed studies show that what common sense tells us should be so is in fact not so?
The puzzle is resolved by reaching an understanding of the difference in the influences on stock prices in the long term and in the short term. In the long term, stock prices are determined by the economic realities. The U.S. economy is sufficiently productive to support a long-term return of a little more than 6 percent real. So long as our economy remains roughly as productive as it has always been before, that number must continue to apply. Long-term stock returns are largely predictable. That’s why long-term timing works. When returns are predictable, timing is an effective strategy.
Timing doesn’t work in the short term because short-term prices are not predictable. Why? Because stock prices are set by humans and humans are emotional creatures. For a time, we can make stock prices whatever we want them to be. Stock prices were insanely high in January 1995. But those who shorted the market got killed. The rest of us reacted with insane emotion to those high prices, pushing prices yet higher and higher and higher for another five years. We have the power!
But not in the long term. In the long term, stock prices must reflect the economic realities or the entire market will collapse. By January 2000, prices had gone so high that all the legitimate economic gains for many years to come were already priced in to the current market price. That ensured that stock investors were going to be disappointed for many years running, eventually becoming disgruntled enough to sell their shares and send prices back to fair value (where they are today).
Short-term timing does not work. Long-term timing does. The reason why is that prices are set in the short term by investor emotion, which is unpredictable, but in the long term by the economic realities, which can to a large extent be known in advance. Our common sense from the pre-Passive Investing era did not mislead us -- price really does affect long-term returns, just as we long believed it must.
The Passive Investing finding that short-term timing does not work was a breakthrough insight. It changes the history of investing. But for investors to make constructive use of it, we must fix the great mistake that unfortunately was delivered to us in the same package as that insight. It’s only short-term timing that doesn’t work. Long-term timing always works. Long-term timing is REQUIRED for the investor seeking a realistic chance of achieving long-term investing success.
Rob Bennett writes the “A Rich Life” blog. He has recorded over 100 podcasts explaining what investors need to understand to make the transition from the Passive Investing model of understanding how stock investing works to the new Rational Investing model.
Editor's note: I will provide a brief critique to Rob's article later this week, but let me steal my own thunder, I think the arguments Rob makes are largely sound, as far as they go.
Enjoyed this post? Please consider subscribing to Money and Such by free RSS Feed or by email. You can also follow me on Twitter.