More Thinking About Market Timing Leads to More Thinking About Market Timing

Doubts About Buy-and-Hold vs market timing price discipline irrational exuberance

Most people put the market timing concept in a box. Most don’t think it’s a good thing. But even those who are open to thinking of it as a good thing don’t think of it as being a big deal. There are lots of things to know about stock investing. Market timing is just one of those things. The topic of market timing is about 5 percent of what you need to understand to become an effective stock investor.

I do not see it that way. I would say that market timing is the most important stock investing topic. To understand the ins and outs of market timing is to understand 65 percent of what you need to know to become an effective stock investor.

Confusion About Market Timing

The confusion stems from the fact that most people think of the foolish form of market timing (short-term timing) as being what market timing is all about. Short-term timing really doesn’t work. Short-term timing is a guessing game. Short-term timing is the approach to timing that critics of the concept point to when seeking to make the entire concept look bad.

For short-term timing to work, you would have to be able to guess right both as to when stock prices were going to turn in one direction and then also when they were going to turn in the other direction. That’s not much to go by in making those guesses since it is primarily investor emotions that cause price changes. So guessing right is difficult.

The magic behind the more important form of market timing (long-term timing) is that the same reality that causes short-term timing always to fail also causes long-term timing to always succeed. Stock price changes are determined by shifts in investor emotion.

That makes stock price changes unpredictable, But stock prices can be removed from the economic realities for only so long. Sooner or later, prices have to reflect the economic realities. So the distance that prices travel from the economic realities tells you a great deal about how stocks will be performing in the long run.

Unlike short-term timing, long-term timing (changing your stock allocation in response to valuation shifts with the aim of keeping your risk profile constant over time) always works. That alone is of course a big deal. It means that investors who are open to market timing can obtain higher returns while taking on less risk.

That shouldn’t even be possible, according to the Buy-and-Hold view of the world. The return that an investor obtains is presumed to be a reward for his willingness to take on risk. In reality, returns can be obtained by being able to see through the irrationality that dominates the market during bull markets.

That’s only the first link in the logic chain. More thinking about market timing leads to more thinking about market timing.

The Irrational Exuberance Phenomenon

Most investors have confused thoughts about what it means for stocks to be overpriced. Most will agree that overpricing exists, that it is possible. But most give little thought to the implications of that reality. There’s a great deal of wealth tied up in the stock market. If that wealth is mispriced, it follows that we really don’t know how much in the way of resources we have available to us.

That’s so not just in the personal realm. It’s not just that we do not have accurate numbers telling us how much we have put aside for retirement. If stocks are mispriced, we do not know how well our economy is doing because, when stocks are overpriced, there is a price crash built into the system and that price crash is going to make trillions of dollars of wealth disappear.

That of course means that businesses will fail and workers will lose their jobs and political frictions will be exacerbated. It even means that businesses that appear to be successful at the time when wealth is overstated will be revealed not to be viable ongoing concerns when prices return to their proper levels.

We like bull markets because they make us feel richer. What’s not to like? The thing not to like is that, to the extent that the added wealth is the product of irrational exuberance, it will not be lasting. It is better not to come to possess added wealth than to come to possess a form of added wealth that will not last.

Pretend, temporary wealth causes all sorts of bad decision-making. Financial decisions are made by looking at numbers. When the numbers used are wrong, bad financial decision-making follows. Irrational exuberance is a cancer on our economic system.

The irrational exuberance phenomenon uncovered by Robert Shiller’s Nobel-prize-winning research is the signature reality of the stock investing experience.

I often reflect how millions of people who would complain if they were overcharged by five dollars for a hamburger are fine with being informed of the value of their stock portfolio with a number that does not contain an adjustment for the amount of irrational exuberance present in the stock price at the time.

A five-dollar misstatement matters. A misstatement of hundreds of thousands of dollars is no biggie. That’s the incredible reality.

Stocks are an amazing asset class. The claims that are made about how they can build wealth quickly are true. Everyone should be invested in stocks. But there is a drawback to investing in stocks and Shiller’s research points to it. Owning stocks leads to self-delusion about how much wealth they are generating at times when we all get together as a nation of people and elect to fool ourselves about the true value of our portfolios.

There will come a day when we will incorporate Shiller’s insights into our understanding of how the stock market works. When that day comes, stocks will be less risky than they are today. We will all practice market timing. The subject will be discussed every day at every web site.

Our willingness to sell a portion of our stocks when prices rise too high will keep prices from ever getting too crazy. So bull markets will be a thing of the past. Which means that bear markets will be a thing of the past. Which means that economic crises (which in the past have always been associated with stock price crashes) will to a large extent be a thing of the past.

It’s all connected. A simple way to think about it is to substitute the word “rationality” for the term “market timing” when you think about it. In all of the markets other than the stock market, people consider price when they make purchases. That’s what keeps the market functional. That’s what permits the market to work its magic of setting prices properly.

In the stock market, few of us do what we need to do to help the market function. We take rationality out of the equation and of course we learn down the line that there is a price to be paid for doing that.

Rob’s bio is here.