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You Don’t Have to Get It Right Twice for Market Timing to Succeed

By robbennett. Originally published at ValueWalk.

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I am a big believer in market timing. My view is that it is through market timing that investors practice price discipline when buying stocks. Which is absolutely critical. Price discipline is what makes markets work. In the event that valuations affect long-term returns (as Shiller has shown is the case), investors must practice market timing to have any hope of keeping their risk profile constant over time. Market timing is a good thing, no matter what the Buy-and-Holders say.


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Stock Market Timing

But the Buy-and-Holders have been successful in creating skepticism are market timing in the minds of millions of investors. What gives? I believe that the most effective argument that the Buy-and-Holders have advanced is the claim that market timers have to guess right two times for their market timing efforts to succeed, once when they get out of stocks and again when they get back in.

I don’t buy it.

Market timers don’t have to guess at all. Market timing is an exercise in risk management, not guesswork. I would agree with my Buy-and-Hold friends that any strategy that requires guesswork is almost certainly not a good idea. But market timing is not such a strategy, at least not when it is employed in an intelligent manner.

The confusion stems from the failure to distinguish short-term timing from long-term timing. Short-term timing is changing your stock allocation with the expectation that you will see benefits from doing so within a year or two. Long-term timing is changing your stock allocation in response to big shifts in valuations with the understanding that you may not see benefits for doing so for 10 years or perhaps even a bit longer.

There really is evidence that short-term timing doesn’t work. For just the reason that the Buy-and-Holders offer. Short-term timing requires that the investor know both when to get out of stocks and also when to get back in. The market is not predictable enough for an investor to get both of those things right. So, if my Buy-and-Hold friends would say only that short-term timing doesn’t work, I would be with them.

What Is Long-Term Market Timing?

Long-term timing, however, is a very different animal. As noted above, long-term timing is how stock investors practice price discipline. When stocks are priced as they were in 1982, the most likely 10-year annualized real return (as determined through a regression analysis of the historical return data) is 15 percent real. When stocks are priced as they were in January 2000, the most likely 10-year annualized real return is a negative 1 percent real. The risk associated with buying stocks is not the same when the most likely long-term return is 15 percent real and it is when the most likely real return is a negative number. So investors simply must practice market timing to keep their risk profile constant.

I have been making this claim at various places on the internet for 18 years now. It clicks with some investors quickly and strongly. But it doesn’t click with confirmed Buy-and-Holders. Confirmed Buy-and-Holders hate market timing and they cannot let in the idea that there might be a type of market timing that both reduces risk and increases one’s lifetime return.

Their hang-up usually is some form of the complaint that investors engaging in market timing must get both the exit point and the re-entry point right. And that is just not so.

The purpose of long-term market timing is to manage risk. Risk management always pays off. But one often has to be patient to see the payoff arrive. An investor might lower his stock allocation to 30 percent when the CAPE level reaches 25 on grounds that stocks have become a lot more risky than they were when he adopted a 60 percent stock allocation with the CAPE level at 16. He might see the CAPE level remain the same or increase for the next 10 years and the Buy-and-Holders might tell him that he missed out on the wonders of going with a high stock allocation at all times by doing so. But no! If he needed to get his stock allocation down to 30 percent to keep his risk profile constant, he did the right thing by doing so. The payoff will come down the road a piece.

Irrational Exuberance

Can an investor really come out ahead after missing out on gains for 10 years?

Yes. I think it helps to keep in mind what gains experienced when the CAPE is 25 or higher represent. They represent irritation exuberance, the phenomenon signified in the title of Shiller’s book. What is irrational exuberance? It is cotton-candy nothingness. It is a kind of gain that shows up in an investor’s portfolio temporarily and then disappears when stock prices return to fair-value levels, as they always do (it is the core job of any market to get prices right). The most important thing that we learned from Shiller is that there are two types of stock gains, gains backed by true economic value, which are the gains earned when the CAPE value is at fair-value levels or lower, and irrational exuberance, which creates only temporary gains, gains that disappear with a change in the dominant investor mood. Smart investors consider how much irrational exuberance is present in the market price when they make a stock purchase, investing less in stocks at times when prices are out of control so that their personal risk profile remains where they intended it to be.

Long-term timers don’t need to identify a good time to lower their allocation. The right time to do it is when the CAPE value has traveled high enough as to send their risk profile out of whack. And long-term timers don’t need to identify a good time to return to the old stock allocation. The right time to do it is when the CAPE value has dropped to an acceptable level. Over the course of an investing lifetime, the investor who always engages in market timing will be richly rewarded with higher returns. But he will of course never know when those returns will come (because of the unpredictability of stock prices in the short-term). His reward is getting his risk profile right. That always pays off in the long term.

No guesswork required!

Rob’s bio is here.

The post You Don’t Have to Get It Right Twice for Market Timing to Succeed appeared first on ValueWalk.

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