I believe that the people who developed the Buy-and-Hold stock investment strategy made a mistake. The Buy-and-Holders often advise investors that market timing doesn’t work. The guessing-game form of timing – where investors aim to make predictions as to when stock prices will rise and fall and to shift their allocations to profit from the price increases and drops – really doesn’t work. But valuation-based market timing – changing one’s stock allocation to keep one’s risk profile constant as the amount of irrational exuberance present in the market price expands or contracts – always works.
Buy-and-holders discourage market timing
To tell investors to forswear market timing altogether is dangerous. The only way to keep irrational exuberance under control is through market timing. When irrational exuberance gets out of control, a price crash follows. Price crashes cause so great a loss of consumer buying power that they produce economic collapses, which of course hurt all of us. Valuation-based market timing is price discipline. A market without price discipline is like a car without brakes. We need to encourage investors to always practice valuation-based market timing. The Buy-and-Holders do just the opposite. They discourage market timing at every turn. Given the risk that this puts us at of suffering an economic collapse, it is a serious public policy concern.
Robert Shiller revealed the danger of the relentless promotion of the Buy-and-Hold strategy with the publication in 1981 of his Nobel-prize-winning research showing the valuations affect long-term returns. If returns are different for stocks purchased at different valuation-level starting points, stock investment risk is not stable but variable. If risk is variable, investors who wish to maintain a constant risk profile MUST engage in valuation-based timing, But the same thing that causes bull markets – the desire of investors to obtain returns from their stock investments greater than what the economic realities justify – causes investors to resist valuation-based market timing. Investors will not engage in market timing unless they are regularly and strongly encouraged to do so. But instead most experts discourage the practice. Hence, today’s CAPE value, which shows that the market is today priced at two times its fair-value price level.
The Buy-and-Holders believe that investors should look to the peer-reviewed research as guidance on how to invest. So I once believed that their opposition to market timing might be supported by research. It is not. There is research showing that the guessing-game approach to market timing does not. But Wade Pfau, a researcher who holds a Ph.D. in Economics from Princeton University, worked with me for 16 months trying to locate research supporting the claim that valuation-based market timing is not required and came up empty-handed. The idea that there is research casting doubt on the need for market timing is a myth.
My sense is that the Buy-and-Holders simply never made the distinction between the guessing-game form of market timing and valuation-based market timing. They were properly persuaded that the guessing game form of market timing does not work and improperly stated their conclusion as an admonition against market timing in general. Index funds were not widely available at the time when the Buy-and-Hold strategy was being developed and valuation-based market timing only works with index funds. My guess is that few appreciated the need to distinguish between the two types of market timing in those days.
I would prefer not to have to guess. It would be nice if there were documents in which the people who developed the Buy-and-Hold strategy described their thought processes. I am not aware of the existence of any such documents. If anyone reading these words is aware of the existence of such documents, I would be grateful if they would bring them to my attention. For now, I need to work on the presumption that no such documents exist.
Which means that there is no support for the widespread belief that valuation-based market timing is not required. Shiller’s research suggests strongly that it is. I co-authored research with Wade Pfau making the point directly. We compared how investors who stayed with a 60 percent stock allocation at all times fared throughout the history of the market compared to investors who went with a 60 percent stock allocation when prices were at moderate levels and with a 30 percent stock allocation when prices were at high levels and with a 90 percent stock allocation when prices were at low levels. The investors who practiced valuation-based market timing obtained higher returns while taking on reduced risk. That’s investor heaven!
The importance of market timing
Why is it that there is so little discussion of the importance of market timing among the investors of today? The problem is that the mistake made by the Buy-and-Holders has been repeated thousands and thousands of times in thousands and thousands of places over many years. There is a great deal of embarrassment among experts in the field over the bad advice that they have been advancing for a long time now. The question of whether investors should be practicing price discipline when buying stocks is a basic question. It would be fair for investors to question what sort of experts could get that one wrong. So we are in a bit of a pickle. We cannot fix the mistake without first acknowledging it but the 43-year cover-up of the mistake looks bad.
Investors need to know that there has never been any serious reason for believing that valuation-based market timing is not required. Price discipline is of course required in every other market that exists. All that Shiller really did is to show that the same rule that applies in every market other than the stock market applies in the stock market as well. I love it that the Buy-and-Holders encourage investors to look to the peer-reviewed research. But, in the case of the mistake they made over valuation-based timing, they failed to follow the careful, formalized procedures that are the hallmark of all genuine scientific investigations.
Rob’s bio is here.
