Many people believe that there’s research showing that market timing doesn’t work.
There isn’t. It’s a myth.
There’s research showing that short-term market timing doesn’t work. That’s where an investor takes a guess as to when a price shift is going to arrive. It’s not hard to figure out why that would not work. As critics of market timing often point out, for that to work the investor would need to guess right both about when to lower his stock allocation and when to increase it. Someone could pull it off by luck. But it seems unlikely that that could work consistently. I think the Buy-and-Holders nailed this one.
But what about valuation-based long-term market timing? That’s been working for as far back as we have records of stock prices. Wade Pfau spent 16 months of his life working with me on research on this question. He concluded that: “Yes, Virginia, Valuation-Informed Indexing (which is Buy-and-Hold with valuation-based market timing added to the mix) works!”
Wade told me that he was amazed by our findings. He kept asking himself if he was missing something because he had heard so many Buy-and-Holders say that market timing doesn’t work but the historical return data shows that it does. I agree that it’s a strange reality.
I don’t believe that the people who developed Buy-and-Hold back in the 1960s were even thinking about valuation-based market timing when they came to their conclusion that market timing doesn’t work. Index funds were not available in those days. Valuation-based timing only works with index funds. With individual stocks, it’s possible that a high CAPE level just means that the company has super prospects, not that investors have acted with irrational exuberance. So I don’t believe that valuation-based market timing was foremost in people’s minds.
Valuation-based market timing always works
Shiller was the first person to give consideration to valuation-based market timing. And of course he found that it always works! If valuations affect long-term returns, as Shiller showed, stock investing risk is not stable but variable. If risk is variable, then changing one’s stock allocation in response to valuation shifts is REQUIRED for investors hoping to keep their risk profile constant over time. In a world in which valuations affect long-term returns (the world we live in, according to Shiller’s research), it is a logical impossibility that valuation-based market timing would not work (at least on a risk-adjusted basis).
So it should be no surprise that it does. It usually does come as a surprise to people who look at the question, however. This question became important to me when I asked a delicate question at a discussion board on early retirement. People there were using a study that claimed that the safe withdrawal rate is always 4 percent to determine when to hand in their resignations to their jobs. I had read in John Bogle’s book Common Sense on Mutual Funds that reversion to the mean of stock prices is an “Iron Law” of stock investing. If that’s so, the safe withdrawal rate cannot possibly be the same number at all valuation levels. So I suggested to the discussion board community that we consider valuations when calculating the safe withdrawal rate.
Holy moly! The reaction was off the charts. In both directions! There were people who thanked me for launching the most valuable discussion in the history of the board. And there were people who – well, let’s just say that there were people who did not welcome the question that I advanced.
Challenging the buy-and-hold dogma
I didn’t realize at the time that I was challenging the Buy-and-Hold dogma that market timing doesn’t work. The people who did not want aspiring early retirees taking valuations into consideration insisted that I was. They argued that valuation-based market timing is every bit as much market timing as the short-term guessing-game stuff. I had to acknowledge that they had a point. So I had to come around to saying that at least one form of market timing works.
That has not become a widely accepted reality to this day, 22 years later. Why? I believe it’s because acknowledging that valuation-based market timing works changes the stock investing game in a fundamental way. If valuation-based market timing works, then people should be lowering their stock allocation when prices get scary high. If people did that, there would be no more bull markets. Which means there would be no more bear markets. Which means there would be far fewer economic collapses. That all sounds fine to me. But apparently there are a good number of others who see little appeal in that sort of change.
It’s a big change, in any event. Until we get to a point where we can discuss these matters frankly at every investing site, I encourage you to consider whether it is possible to have a world in which valuations affect long-term returns and in which valuations-based long-term timing doesn’t work. I say that it’s a logical impossibility. If you come across any evidence that valuations-based long-term market timing doesn’t work, I would sure be grateful if you would pass it along. I don’t believe that you are going to come up with anything. If you do, it might make you famous. You will be the first to do so!
Rob’s bio is here.
