The Truth about Market Timing

The following is a guest post by Michael A. Gayed, CFA, Chief Investment Strategist, Pension Partners, LLC. We've discussed this line of thinking previously, but I think it's good every now and then to re-stir the pot. ;-) 

The post titled Market Timing Doesn't Work. Yes, It Does. No, It Doesn't. Yes, It Does addresses conflicting opinions about the validity of market timing.  The big question, however, is WHY it does or doesn't work.  To answer this, let's take a look at some actual hard facts about the nature of equity price movements by taking a look at the S&P 500 ETF (Symbol: SPY).  Take a look at the chart below (click to enlarge):

 
What I did here was download the daily price data for the SPY ETF since inception (1993), ranked the daily returns, and came up with different returns patterns based on whether you were in the market in the best or worst performing days.  The blue line represents a simple buy and hold strategy (with no market timing).  The red line represents what the return would have been if you had timed the market and happened to have missed the 10 best days of performance.  The yellow line is the return you would have seen if you had timed the market so perfectly that you were not exposed to the 10 worst days.  Finally, the green line shows what would have happened if you had missed the 10 best and 10 worst days of performance.

Here's how the performance ends up:

• Growth of $100,000 from 1/29/1993-8/30/2010
• Buy and Hold: $324,330.15
• 10 Best Days Removed: $156,354.12
• 10 Worst Days Removed: $692,693.90

The difference in performance is enormous.  We're talking about timing just 0.2% of the days in the sample period.  Think about this for a moment: 10 days account for most of the return!  Market timing becomes extremely difficult because the odds are against you – you have to be in the market's best performing days, and out of the market's worst performing ones.

But what is the risk?  I argue that the risk is NOT the yellow 10 worst days removed line, i.e., not in outperforming, but in missing the best days.  The truth is buy and hold appears to work in an almost lottery type fashion—you have to be in it to win it for those low probability, high impact (Black Swan-ish) days for the compounding effect to really make a difference cumulatively.

What's the takeaway for you?

• Recognize that equity price pops and drops are largely unpredictable, yet account for most of the cumulative return
• Don't over-trade and try to pick up pennies in front of a steamroller since performance is driven by the rare $100 bill trades (10 best days)
• It’s okay to vary your exposure to equities, but do so with a broader asset allocation plan in mind
• Being contrarian is a lot easier said than done—be honest with yourself in terms of what can and can not be accomplished through active trading.

Comments

[Matt]

I never tried to market time and just about everyone I know who did usually eneded up buying high and selling low. More of euphoric/panic buying and selling. I use to be aggressive but this aggressiveness had a big swing this last time that changed my thinking.I know way to many of my coworkers who at the low over the past two years needed to cash out alot and they lost alot. It took nearly two years for my portfolio to recover from the drop but in that two years I lost growth. I am slowly ( not trying to time the market or panic selling) to a less aggressive portfolio because I realize that I am getting older and closer to "that age of retirement" and I can't keep investing like a 30 or 40 year old.

[DIY Investor]

The risk isn't just missing the best 10 days. Redo your numbers and see what happens if you miss the best 15 days or best 20 days. The story is told of the woman who got out of the market two days before the 10/87 crash (down 24% in 1 day). She was tracked down and interviewed sometime later after the market had recovered and asked when she had gotten back in. She never had.
Talk to people who were boasting that they got out in 2008. Many never got back in and the market took off in 3/2009-just when it looked like the world was coming to an end by the way.
Market timing is possible but it is nowhere near as easy as it looks. At least that's my take.

[kip]

I don't think there is a thing as successful market timing as there is the change for successful sector and industry allocation on a macro level. However, there is also the disciplined approach of investing in what you know and the products that you use. Quality of your dish soap goes up, buy P&G. Your new car breaks down, sell Yugo. If there is any indicator in the value of a firm it is the overall quality that is passed to the consumer.

[MonkeyMonk]

This is an interesting chart. I'd love to see a more detailed version that presents other "what if" scenarios like, e.g., an investor missing the 5 best days but also missing the 8 worst days.

I'd done some light market timing over the past decade with consistently better than average results. I'm just shooting to missing more "worst" days than "best" days. In this last crash I was lucky enough to get out of a good portion of equities fairly early and bought back in with those proceeds as the market continued to decline. I totally realize there is a strong element of luck at play but when the market was tanking in 2008 it just seemed obvious to me that the shit was hitting the fan. Holding onto all my equities as they lost value just seemed like a silly move plus making the earlier sale gave me extra proceeds to use to buy back in while the markets continued to decline.

[Rob Bennett]

I am grateful to you for running this post, FMF. I believe that the question of whether market timing works or not is the most important question in personal finance today. I know that you do not personally support market timing, FMF. By presenting posts on it, you are helping people sort through the questions. That is a big deal and a big help.

You are making a mistake that I have seen Buy-and-Holders make thousands of times, Michael. You are confusing short-term timing with long-term timing. You present strong evidence that short-term timing doesn't work. The research has been showing this for 40 years now. So I don't view this as being much of a biggie. You are presenting no case whatsoever that long-term timing does not work. That's what people need to learn about. That's the "controversy" (I put the word in quotes because there is no real controversy here -- there is a mountain of evidence showing that long-term timing always works and that short-term timing never works.)

The key to understanding what is going on is appreciating why short-term timing is so different from long-term timing. In the short-term, stock prices are determined by investor emotion. For short-term timing to work, you would need to know in advance which way investor emotion is headed. Emotion is by definition highly irrational. So how the heck can anyone make effective guesses?

Long-term prices are determined by the economic realities. The economic realities are highly predictable. The U.S. economy has been sufficiently productive to support a long-term average return of 6.5 percent real for as far back as we have records (1870). So long as that remains even roughly so, long-term timing will continue to work. It's not even possible for the rational human mind to imagine a circumstance in which long-term timing would not work, unless we see a collapse of the market (in which case we would be better off not to invest in stocks at all).

We very much need a national debate on Shiller's 1981(!) finding that long-term timing always works. Having that debate is the key to bringing the economic crisis (brought on by the reckless promotion of Buy-and-Hold strategies) to an end. The key to getting that debate off on the right foot is being careful to distinguish the short-term and long-term varieties of market timing.

Yes, there is one form of timing that never works and that's an important insight that is properly credited to the Buy-and-Holders. But, no, the finding that short-term timing doesn't work in no way, shape or form lends support to the idea that timing doesn't work. Long-term timing is critical to long-term investing success. There has never yet been a time in history when Buy-and-Hold worked in the long-term. We will never see such a time. Failing to time the market is failing to take price into consideration when buying stocks and that cannot possibly be a good idea.

Rob

[Tyler]

10 best and worst days since 1993- so 10 days out of 4,250 trading days (250*17).

To me, market timing involves adding or reducing exposure as risk factors increase or decrease. Risk adjusted returns are therefore an important consideration when doing any market timing analysis. A strategy might be advantageous if it underperforms a buy and hold strategy but has less risk. This underperformance in theory can be offset by leverage or position size to exceed the buy and hold strategy’s absolute returns.

“you have to be in the market's best performing days, and out of the market's worst performing ones.”

This is false. In the overly simple analysis, this might look true, but adjustment for other factors such as net exposure will change this statement. One of the major mistakes analysts make is to draw powerful conclusions from overly simplistic tests. I can assure you this conclusion misses a lot of returns. Especially when its based on 20 days out of 4,250 or roughly 1 day per year of the sample period.

What if I could avoid the 10 worst days, the 10 best days, any day with SPY move less than +/- 0.5%, and had compounding exposure in the direction of the SPY move every other day? I’d crush it. Exclude gaps if you want so I have zero overnight exposure, add and subtract leverage for other factors… I’d be in Forbes! Yet I’d also miss all of the days you claim I require.

“Being contrarian is a lot easier said than done—be honest with yourself in terms of what can and can not be accomplished through active trading.” Very good advice. My debate is not that all of us should become traders. I do believe that every investor should investigate different strategies, and remain intellectually flexible to new strategies and analysis.

If I had to find some value in this analysis, it would be the Green Line and its relationship to the Buy and Hold Blue Line.

[Jeff]

Well said, @Rob. It seems one can time the market over the long term. I really liked the book, "Yes you can time the market" by Ben Stein - it makes a ton of sense to me.

[Tyler]

Rob- what is short and long term to you?

Absolutes in investing and finance seldom hold true. You'd clearly disagree.

HFT would likely disagree with you... and so would their returns.

[Rob Bennett]

Absolutes in investing and finance seldom hold true. You'd clearly disagree.

I agree with the way you said it, Tyler. You said: "Absolutes iin nvesting and finance SELDOM hold true." Something that is seldom true is sometimes true. This is one of those rare cases in which an absolute really does hold up. I'd be grateful if you would think through why I say that before dismissing the idea out of hand.

When I say that long-term timing always works, all that I am saying is that the price you pay for stocks MUST affect the value proposition you obtain from them. If I were saying this about anything other than stocks, you would instantly agree. If I said that it's a bad idea to pay three times market value for a car, you would sign on to the idea in a minute. Stocks were selling at three times market value in January 2000. All that I am saying is that the same rules that govern car purchases also govern stock purchases.

Rob- what is short and long term to you?

I define "long term" as ten years out.

I invite you to go to the historical stock-return data (available at Shiller's web site) and pick a stock allocation based on the P/E10 level for any year going back to 1870. Then check where stock prices stood 10 years later and whether long-term timing ended up working for you or not. You won't find any cases in which long-term timing did not work out at least reasonably well after the passing of 10 years.

There is no magic to 10 years, of course. Long-term timing sometimes works out in five years. There are a small number of cases in which it took 11 years or 12 years to pay off. I have a calculator at my web site ("The Investor's Scenario Surfer") in which you can test how long-term timing works in an unlimited number of realistic 30-year returns sequences. It shows that long-term timing (Valuation-Informed Indexing) yields better results than Buy-and-Hold in 9 out of 10 possible sequences. In some cases it leaves you with a portfolio DOUBLE the size of what you would get with Buy-and-Hold at the end of 30 years.

It is not my intent to hurt anyone's feelings by telling people this. The fact that timing always works is NOT bad news. It is wonderful, wonderful news. I hope and believe that there will come a day when Buy-and-Holders will be willing to discuss these ideas in an open and civil and reasoned debate. We are on that day going to be well on our way to learning how to invest in ways that provide far higher returns at far less risk. That is a plus for every investor alive. We just need to stop looking at Shiller's findings as a threat and begin seeing them for the wonderful breakthrough opportunity they truly represent.

Rob

[Michael A. Gayed, CFA]

Rob,

Thought I'd chime in here since my post was put up thanks to the kindness of FreeMoneyFinance.com. My question regarding long-term timing is: how do you define and identify an economic shift until after the fact? Now, most investors and traders like to focus in on the 200 day moving average to get a sense of the economic shift, and time market entry and exit based on whether averages are trading below (bear market/contraction) or above (bull market/expansion) the long-term price average. If you take a look at the 100+ year history of the Dow, long-term timing based on the above methodology still produces inferior returns to buy and hold.

In my testing, 32 our of the 40 most extreme performace days (20 most up and 20 most down) occur underneath the 200 day moving average. This is why I present an example of what the buy and hold performance of SPY would be if you removed the 10 best and 10 worst outlier days. You end up getting the same result over time as if you held the market throughout.

I do, however, believe that market timing based on long-term averages makes sense when you're talking about rotating out of equities and into bonds. Consider this: stocks are supposed to "anticipate" the future. In contrast, the Fed only reacts to the present and will really only begin an interest rate hiking or tightening cycle after the economic data has shifted. This is an exploitable opportunity - rather than time equities in terms of whether to go long or short/cash, academic research does indicate that going long equities when above a longer-term average and then rotating out completely into bonds does produce better cumulative returns.

All the best, and Happy Thanksgiving everyone.

Michael A. Gayed, CFA

[Tyler]

Rob-

The only constant in finance is change. I am skeptical of everything that 'works' today and dismissive of anything that claims to always work. I rarely dismiss anything that has solid research behind it.

Markets can remain irrational far longer then you can remain solvent. I believe valuation and valuation metric change over time. The price I pay for something is simply the price I pay. Value and price are seldom the same.

"the price you pay for stocks MUST affect the value proposition you obtain from them"

You have this backwards, the value I propose affects the price I will pay. What I pay for something doesnt change my value proposition (whatever that means).

I buy and sell cars on the side. Trust me, people pay more or sell their car for less than the 'market' rate. Regardless of how you define market value, I can show you assets that are over and under value with willing participants making a trade.

P/E of 10? If we are going to mine historical data lets get accurate here... why not 9.7654? or 10.6543? Your sample portfolio doesnt tell me anything about the future. Here is my point, give me any rule you want, and I can produce for you a period of time where it works.

Feelings have nothing to do with it- you're not hurting my feelings nor are you providing anything as revolutionary as you seem to think. (Hope I didnt hurt your feelings)

[Rob Bennett]

My question regarding long-term timing is: how do you define and identify an economic shift until after the fact?

Thanks for your question, which is a good one, Michael.

There's no need to identify any economic shifts with long-term timing. I am in the camp of the Buy-and-Holders on the question of identifying economic shifts -- I don't think it can be done effectively. So I don't make any effort to identify when economic shifts are coming.

Long-term timing (Valuation-Informed Indexing) is about comparing value propositions. The idea is to invest heavily in stocks when stocks offer a stronger long-term value proposition than the super-safe asset classes (TIPS, IBonds, CDs) and to invest heavily in the super-safe asset classes when the super-safe asset classes offer a better long-term value proposition than stocks.

A regression analysis of the historical stock-return data shows that the most likely annualized 10-year return for stocks at the prices that applied in January 2000 is a negative 1 percent real. TIPS were at the time paying a guaranteed 4 percent real. So TIPS offered the far better long-term value proposition. A Valuation-Informed Indexer would have been at a low stock allocation in 2000.

Stocks offered a poor long-term value proposition for the entire time-period from January 1996 through September 2008. So there was no need for a Valuation-Informed Indexer to make any allocation changes during that time-period. There obviously were economic shifts taking place. But none of them caused stock prices to drop enough to bring the long-term value proposition for stocks back to reasonably appealing levels. So there was no need for allocation changes.

The time when an allocation change was needed was in early 1996. That's the point at which the price level for stocks rose so high that you could get a better deal by investing in super-safe asset classes. Why take on the risks of stocks if there is not likely to be any long-term payoff for doing so?

Rob

[Rob Bennett]

"Feelings have nothing to do with it- you're not hurting my feelings nor are you providing anything as revolutionary as you seem to think."

I know from long personal experience that pointing out what the historical data says on these questions hurts the feelings of many Buy-and-Holders, Tyler. I am happy to hear that this is not the case with you. It is certainly not my intent to hurt anyone's feelings.

I think you are wrong to believe that this is anything short of revolutionary. If we have learned how to time the market effectively (this is my claim), we know how to obtain far higher returns at far less risk. If we know when crashes are coming (there has never been a crash of any lasting significance that did not start at a time when prices were at insanely dangerous levels) and step aside when we know they are coming, we can accumulate the assets we need for retirement in far less time.

We have had four economic crises in the United States from 1900 forward. Each and every one of them was preceded by a run-up in stock prices to near two times fair value. If we teach investors the realities, we will never go to two times fair value again (investors who understand the realities will lower their allocations when prices get too high and those sales will pull prices back to reasonable levels). So we greatly diminish the risk of us suffering another economic crisis if we teach people the realities. This is revolutionary stuff.

"Markets can remain irrational far longer then you can remain solvent."

Huh? My money has been in TIPS, IBonds and CDs paying 3.5 percent real or better since 1996. How can I ever go insolvent with my money in super-safe asset classes paying solid positive returns? I am ahead of the Buy-and-Holders during that time-period, Tyler. Are the Buy-and-Holders insolvent?

"The price I pay for something is simply the price I pay."

Are you saying that you would gladly pay $90,000 for a car with a fair market value of $30,000 because once you pay the $90,000, $90,000 becomes the price you paid? If so, I don't get it. I want to pay a FAIR price, a reasonable price.

"What I pay for something doesnt change my value proposition (whatever that means)."

I think it does. If I pay $15,000 for a car with a fair market value of $30,000, I feel that I have taken advantage of a great value proposition. If I pay $90,000 for that car, I feel that I have obtained a very poor value proposition indeed. I say that we should buy stocks in the same way that we buy cars (and bananas and comic books and every other thing we buy with money).

"Trust me, people pay more or sell their car for less than the 'market' rate."

I am not questioning whether people make mistakes when buying cars, Tyler. I am saying that we should not encourage people to make mistakes. We should encourage people to take advantage of good deals and to avoid overpaying. We should encourage that both when people are buying cars and when they are buying stocks.

"If we are going to mine historical data lets get accurate here... why not 9.7654? or 10.6543?"

Why is the speed limit 65 rather than 63 or 68? Because we have to have a speed limit. If we don't, lots of people will get killed. Similarly, we need to tell people how dangerous it is to buy stocks when they are selling at the prices that applied from 1996 through 2008. Stocks are not dangerous when the P/E10 level goes from 14 or 15 (fair value) to 16 or 17. But they are dangerous as all get-out when they go above 25, as they did in 1996.

They are insanely dangerous when the P/E10 goes to 33, as it did in the months before the Great Depression. And they are something worse than insanely dangerous when the P/E10 is 44, as it was in January 2000. The economic crisis we are all living through today is the inevitable consequence of our collective unwillingness to establish a reasonable speed limit for stocks and to promote it widely.

"Your sample portfolio doesn't tell me anything about the future."

What tells you about the future is your model for understanding how stock investing works. If you believe that valuations don't matter, future events are random -- you invest without any idea of what is coming up ahead. If you understand that valuations matter, you always know where long-term returns are headed long before they get there.

A statistical analysis shows that the investor who looks at the P/E10 value before buying stocks thereby obtains 78 percent of the information he needs to know to identify his 20-year return. A investment for which the long-term return is only 22 percent uncertain is not a risky asset class. Stocks are far less risky than bonds for investors who are willing to take valuations into consideration when setting their allocations. Again, that's a revolutionary finding. People have for many years thought of stocks as being more risky than bonds.

"give me any rule you want, and I can produce for you a period of time where it works."

Valuation-Informed Indexing has provided higher returns at dramatically less risk for the entire time-period from 1870 to 2010. That's 140 years. And those are the only 140 years for which we have data. Are we to believe that that is pure coincidence? My view is that the historical data is trying to tell us something of great importance -- the price we pay for stocks matters, just as our common sense tells us it must.

Rob

[Apex]

I think FMF just likes to put up posts with the 10 best days argument to push my buttons.

Well, button pushed:

The 10 best days argument is the worst argument against timing there is. It is the evidence of a person who doesn't really understand what he is talking about. People who don't know how to make a good argument latch on to this one because it sounds convincing and they think they have said something profound.

In fact they have said something profoundly stupid and something that doesn't occur anywhere in the real world.

No one misses only the 10 best days (if he did, he is the best timer ever). Or even mostly good days and gets the bad days. Good days are often followed by bad days.

Look at the stock market of the last few weeks. Up 150 one day, down 150 the next. Yesterday and today are a perfect example.

This kind of argument is just horrendous. It is tiring how often it is trotted out and I encourage the person who posted it to think about the argument and realize how stupid it is. If you want to make a case against timing, do it based on an appreciating market and not having enough information to know when the market is going to turn and over-valued markets having a tendency to stay over valued for a long time, etc. You are a CFA for God's sake. I assume you have better arguments than the 10 best days argument. If you don't I wouldn't give you 2 shinny pennies to manage. I understand it's a more complicated argument to make. Isn't that your job? The one you make is facile, completely irrelevant to the point, and could be made by anyone with any math understanding at all. And easily refuted by anyone with any math understanding too.

This is like the 4th time an anti-timing argument has been posted here at FMF. Each time it is I encourage someone to please make an anti-timing argument that doesn't use the X best days argument. No one seems to be able to do so. That sure doesn't speak well for the evidence on the anti-timer side of the argument.

Please try again. This argument is rejected because it is bogus.

[FMF]

Apex --

;-)

FYI, I told the guest poster to be prepared to defend himself because some (many?) of my readers disliked this argument.

[LotharBot]

You can't "time the market" in the sense of being able to dodge just the ten worst days, or otherwise consistently pick the day-to-day movement of the market. You can't consistently pick exactly when the market is going to turn; nobody was like "the Dow and S&P 500 will hit a high on Oct 9, 2007 and a low on March 9, 2009". That type of timing -- picking specific days the market will turn or have great/terrible returns -- doesn't really work.

On the other hand, you can "time the market" in the sense of recognizing that certain areas are over-valued or under-valued for the long term, and therefore picking good days on which to buy or sell those things. There were plenty of people who realized in September and October of 2007 that the market was overvalued, and who realized in February and March of 2009 that it was undervalued. If the $100k investor had completely cashed out of the market Oct 31, 2007 and completely bought back in March 31, 2009 (reacting a few weeks after the top and the bottom, and holding US Dollars in between), he'd finish with $629,815.19. In other words, he'd be less than 10% behind the impossible-to-replicate "miss the 10 worst days" performance, without doing anything more sophisticated than selling when it seemed an overvalued market hit a downturn, and buying when it seemed a way undervalued market hit an upturn.

I just started my saving/investing career in early 2007, and due to my impression that the market was overvalued, I was already holding cash. Bought in to the market in March of 2009. So I'm not talking pure theory; I'm talking about a strategy that actually worked for me. It's not "market timing" in the sense of guessing the exact top or bottom, just in the sense of noticing bad deals and good deals.

[MBTN]

The flaw in the market timing FOR THE AVERAGE INVESTOR is that any trend that is discovered is exploited which in term alters the price of the asset in question. Let's take a simple example. Let's say that there is a trend that the stock market goes up 10% every Thursday. Once you discover this trend, the logical thing to do would be to load up on stocks on Wednesday in anticipation on the Thursday advance. However, what is going to happen in practice is that everybody on their mother will eventually notice this trend and everybody will start buying stocks on Wednesday. That means that the price of stocks are going to go up on Wednesday due to the higher demand, which will effectively neutralize the trend.

Now smart people might start to load up on stocks on Tuesday in anticipation of the Wednesday advance. However, once enough people start to do this, then this will effectively neutralize the Wednesday advance.

And so on and so forth.

My point is that any observable trend, whether it is short term or even long term will eventually be exploited and lead to a neutralization of that trend. I don't know about this Shiller theory about long term timing, but if he has a wesbsite then whatever he knows is probably also known by literally millions of other people who are eager to exploit his theory, which will neutralize whatever trend he noticed. If he noticed that you should buy when the P/E ratio is above X, people are going to start to by in anticipation, causing prices to rise, and eliminating the trend.

Now the average investory always thinks, "Hey I am smarter than everyone else. I noticed a trend that nobody else knows about. I am going to make a killing." Odds are that there are thousands of people who have noticed this trend. There are people who spend their lives pouring over data, crunching numbers on supercomputers, looking for the next big trend, and even those people don't have a lot of luck with market timing. What hope does the average person who does investing as a hobby have when competing with that type of firepower? Very little. That's not to say that there aren't a few who can time the market successfully. However, you have to be truthful with yourself and ask yourself if you really have the time, resources, and talent to really time the market better than everybody else.

Consider the stock market crash that we just had in 2008-9. March 2009 saw massive outflows of money from stocks and stock mutual funds. At that time, 99.9% of the investing public believed that the sky was falling and stocks would keep dropping like a rock. Even the so-called experts were saying there. I don't remember hearing very many voices who said, "This selling is crazy. The stock market was going up." It is easy in hindsight to see that the stock market was way undervalued at that point in time, but very few people had the foresight to realize what was going on, especially among the casual investors, which most of us are.

Is it possible for somebody to successfully identify trends and time the market movements? Yes it is possible. However, it require identifying a trend or pattern that nobody else has seen and exploit it before anybody else notices it. That is a tall order for those of us who actually have jobs in something other than investing.

[Michael A. Gayed, CFA]

DIY Investor - you bring up a very very good point here. In discussions with investors who defend market timing, I often here about how someone got out at the top (as in the example of the woman before the '87 crash), which sounds like great timing right? Of course the issue is that you have to time it and get it right twice...you have to know when to buy and when to sell over an extended period of time.

Kip - your point about shifts in sector and industry allocation is extremely valid. In every economic cycle, there are certain sectors which will outperform (up more, down less) than others. While extreme up and down days are highly beta driven, everything else is sector rotational driven for the most part as academic research does indicate.

MonkeyMonk - 2008 was a great eample of missing worst days. Much of the loss in equities for the year occurred really in just a few weeks. I know of many successul managers who avoided the losses, but also failed to invest back into the March lows, missing the enormous rally seen in 2009. Over the two year time frame, these managers still performed in line with the S&P 500 on average given the V-shape move.

Rob - just an additional response to your initial post. In my writing, I purposely capitalized "WHY" it does or doesn't work. My purpose in this was to posit an explanation for the why, rather than the question most people focus on which relates to whether timing can be done successfully or not. Furthermore, what we're talking about here is buy and hold in the context of equity price movements. This is completely separate from an asset allocation approach which attempts to dynamically re-weight equities relative to other asset classes depending on economic conditions and lagged cross asset class effects.

As to your second post, equities do not follow a normal distribution - there is kurtosis/fat tails in price performance. What this means is that it is unclear if going back to 1870 is enough data from a statistical standpoint to say long-term timing "always works" - the future is unwritten. Having said that, your argument about reweighting a portfolio which contains other asset classes less susceptible to performance being driven by just a few days does have merit because of the nature of where returns come from (income vs. gains).

Apex - I refer to the fact that I am adressing the "WHY" timing does or does not work. My point is that the reason WHY buy and hold has worked is because of exposure to the best days. Believe it or not, I'm not making an anti-timing argument here. Everyone on Wall Street touts buy and hold, but few have an understanding of why it works (extreme days compounded over long periods of time). If investors understood the why better, I suspect there would be much more cycnism over analyst conjecturs made daily on popular media.

Your tone aside, you are correct about "volatility clustering" which is the reality that extreme up or down days are often followed by the exact same response within days. As I mentioned in a prior reply, most extreme up and down days occur under the 200 day moving average. However, timing (long stocks or short stocks/long cash) based on that alone still does not produce better results than if you rode out the decline to begin with. It just results in less volatility.

Tyler - to your first post: I actually very much agree with your premise of adding or reducing exposure to equities depending on certain risk factors. Asset allocation and rebalancing as risks increase or decrease can result in significantly better performance than just holding on to any single asset class over time.

[Old Limey]

Rob Bennett: I fully agree with your belief that short term timing is very hard to achieve successfully whereas longer term timing (holding a position for several months) is a lot easier to achieve.
The only other point I would like to add is that in my trading experience over many years I have found something that is very obvious but that has not mentioned and also doesn't appear to be widely recognized, and that is the importance of "Volatility", particularly "Downside Volatility" as measured by the Ulcer Index. If you work with low volatility mutual funds you will have a higher percentage of winning trades than if you work with highly volatile issues.
Compare Pimco's Institutional Total Return Bond fund, PTTRX with the Nasdaq 100 for the last 22 years since 9/1/1988, the start of my database.

......................Ulcer Index..........Worst Drawdown ................ Ann% (Buy & Hold)
PTTRX ..................1.63 ...................... -6.63% ...........................9.0%
NASDAQ 100 ....45.11 .................... -82.9% ...........................12.1%
VFINX .................16.82 ................... -55.26% ...........................9.42%

The bond fund has only 3.6% of the volatility and only 7.9% of the worst drawdown compared with the very volatile Nasdaq 100 index. This makes the bond fund much easier to work with, it gives you plenty of time to make your decision and especially when you have a nice gain, the gain doesn't slip away from you anywhere near as fast as it would with the highly volatile index.
I also added the data for VFINX, Vanguard's S&P500 fund that is a favorite of many Buy & Hold investors. I think when you look at the drawdown of -55.26% for VFINX and compare it with the performance of PTTRX you can make an excellent case that a good Total Return Bond fund and not the S&P500 have provided by far the most comfortable ride over the last 22 years for the Buy and Hold community.

Another class of funds that frequently have nice gains along with inherent low volatility are junk bond funds making them quite easy to time successfully while keeping your switches per year in the range of 3 or 4 at the most.

Some mutual funds however in the last few years have started enforcing short term redemption fees of
1% or 2% for funds held less than a prescribed time in order to discourage frequent trading so that is another issue that investors need to be aware of before they buy shares.

[Rob Bennett]

"What this means is that it is unclear if going back to 1870 is enough data from a statistical standpoint to say long-term timing "always works" - the future is unwritten."

Thanks for your fair response, Michael.

When I say that long-term timing always works, that's Rob Bennett talking. Rob Bennett is not God and so it is entirely possible that I am wrong. This has happened on numerous occasions in the past and it could well be that it is happening again. I have to say what I personally believe. We are all compelled to do that. But I am grateful to you for adding a bit of balance by noting that we indeed do not know the future. It could be that there is going to be some new development that is going to shoot down all of what I say.

The reason I describe your comment as fair is that I hear in your words at least a tentative acceptance that there could be something to what I am saying. The reason that I state things in a way so strong that many find my words shocking is that I have been exploring this new model (it is a Shiller-rooted model rather than a Bogle-rooted model) for a long time and I have come to have a great deal of confidence in it. If the model is right, then a lot of things that sound shocking to those who have followed the Bogle model really are true. But it would of course be a terrible mistake for anyone to believe that the model is right just on my say-so.

What I believe we need is a national debate on these questions. The full reality here is that we just do not know as much about how stock investing works as we sometimes like to pretend we do. If market timing works, as I and a good number of smart and good people believe, you are doing harm when you try to persuade people that market timing does not work. I don't think that that is your intent. I know that there are many smart and good people who believe as you do, that market timing does not work. It is my view that we all need to aim to speak in less dogmatic ways. It might be possible to add caveats to your claims, to say that you personally believe that there are certain forms of market timing that do not work.

We're all aiming at the same goal. We all want to invest effectively and to help others to invest effectively. When we state things too dogmatically, we get backed into corners and close our minds to ideas that might in the end prove very helpful. I have learned a great deal from many Buy-and-Holders and I am grateful. I hope that over time the Buy-and-Holders and the Valuation-Informed Indexers will be able to talk things over as friends and help each other to learn as much as possible about these important topics. You've been a help in that effort in the way in which you have responded to questions put to you here and I thank you for it, Michael.

Rob

[Rob Bennett]

"equities do not follow a normal distribution - there is kurtosis/fat tails in price performance. What this means is that it is unclear if going back to 1870 is enough data from a statistical standpoint to say long-term timing "always works""

I understand the point you are making here, Michael. I have a question about it that I think might help dispel some of the confusion if we could come up with a good answer to it. You have more of a technical background than I do. Perhaps you know whether anyone has ever looked at the matter that I am asking about.

Stock prices do not follow a normal distribution. Coming at this from the perspective of someone who follows a Shiller-rooted model, I do not find this reality so compelling. My view is that the stock price that applies on any given day is determined primarily by investor emotion. So all that we are saying when we say that stock prices do not follow a normal distribution is that human emotions dance around in crazy patterns. I can see how that could be so. I do not find that too shocking.

It is my belief that determining the true value of the market is a two-step process. First, you determine the nominal price (the S&P value). Then you apply an adjustment for the extent to which the nominal price has been affected by investor emotion (the P/E10 value tells you how much of an adjustment is required to get to fair value). The combination of those two steps tells you the true market value at any given time. We KNOW (on some level of consciousness) the true price of stocks at all times. We hide this knowledge from ourselves (for emotional reasons) because we prefer using the non-real, emotional price in our financial planning efforts.

What if we tracked the REAL market values rather than the nominal prices? Would that be a nominal distribution? I don't know the answer to this question. I don't have the statistical skills to perform the test myself. But it seems to me that we might get a different answer if we set things up in different ways. It seems to me that Buy-and-Holders frequently set their tests up in ways that ASSUME investor rationality and tests set up that way of course do a poor job of revealing the core flaw of the Buy-and-Hold Model -- its flawed assumption that investors set prices rationally.

The other concern I have re the comment of yours that I have quoted above is that, if we really believe that we do not have enough data to show that long-term timing always works, should we not also be saying that we do not have enough data to support any of the principles of Buy-and-Hold? You used data to make the case you made in the blog entry. If the data is not sufficient to show that long-term timing always works, is it not fair to say that the data is not sufficient to support your claim that timing doesn't work?

My view is that, if we go by the data, we have to accept that the entire historical record shows that long-term timing works. But if we say there is not enough data to draw any conclusions, we need to reject the data showing that short-term timing doesn't work. Without data, we are left with common sense. And common sense says that long-term timing should always work (since paying attention to price always works with everything else we buy). Both analytical approaches (data-based and common sense) ultimately take us to the same place.

Rob

[Mark]

From personal experience, short-term market timing works. I've already explained my method in previous posts. Everyone seems to be making it more complicated that it really is, and/or setting an unrealistic expectation of what is a good annual return, or "beating the market" every year (which is more short-term thinking). If you're interested in how I've managed to get 10+/-2% annual returns every year since 2000, I can explain it to people with open minds. But if you just want to argue, I won't waste my time.

[Michael A. Gayed, CFA]

Old Limey - an excellent point here. Because bond returns are primarily driven by income, they are less susceptible to extreme days (both up and down) making their inherent volatility less. Furthermore, because bonds expire (once they mature), the ability to continuously trade bonds is diminished, meaning that investor emotion can not express itself as easily as it does with (continuous) stocks.

Rob - certainly a well-thought out response. Let's backtrack a bit: how do we define market timing? Is it a binomial decision (i.e., either go long stocks or hold cash) or some variation? In its purest form I think that's the way most investors think of it. The evidence is overwhelming that in terms of actual returns, investors who actively trade end up having inferior returns compared to a buy and hold strategy involving just the S&P 500 (refer to the Bogle study on ETFs for this). Active market timing (again, using the binomial approach I mentioned above) generally occurs because of "overconfidence" in one's ability to time the market. The feeling of control ends up being detrimental once you look at how much single day extremes can impact overall cumulative performance.

I 100% agree with your premise that the reality is few people understand how stock investing works - we often believe we undertand what's occurring after the fact (Nassim Taleb's "narrative fallacy" concept) so that it all seems clear in hindsight, but never when we're in the middle of the move. Again, my intention here is more to state WHY buy and hold has been shown to work. The evidence is on the side against market timing because of the actual studies done on performance of market timers. Now, there are certainly people who are able to state that they've achieved strong consistent returns by timing the stock market (again, long equities or holding cash), however there are always "winners" in a sample - the problem is we can not quantify how much of one's performance is attributable to luck (best days/worst days) or skill. What this means is that there needs to be a much bigger dosage of humility in the way we perceive the sources of stock returns.

Now, if we assume that the question should be framed not in terms of long equities/hold cash, but rather discuss the idea of asset allocation and rebalancing overall equity exposure relative to other assets (specifically bonds) during different cycles, then I think investors would be better served in the long term. As I've mentioned before, there are studies that indicate that cross-asset performance acts with a lag, such that it is possible to dynamically reweight a portfolio to generative stronger returns than if you just held the stock market all-in.

As to your point about investor emotion - I wholeheartedly agree. I'm actually an enormous fan of behavioral finance because I deeply believe that psychology impacts stock prices far more than earnings do in the short run. However, what the "true" value is will never be clear. We can say with some level of confidence that markets are overvalued or undervalued, but never by how much with 100% certainty. The issue is that true values can take a long long time to manifest themselves. For retirees, time may not be on their sides to wait that process out. Liquidity needs do come up, which can force an investor out at inopportune times.

As to your point regarding buy and hold and not having enough data as to why it works, I actually agree with your premise. However, I'm coming at this from a relative perspective. Relative to the vast majority of market timers during the exact same period, buy and hold has performed better. There is a structural reason for why this MAY continue to be the case (and now to bring a wrinkle to this discussion). Most investors who "time" the market are doing so to achieve capital gains and avoid capital losses. In other words, it does not have to do with dividend or income timing. Buy and hold captures those divideds, while timing for the most part does not.

Take the Dow Jones Industrial Average, for example. Since inception of the 100+ year history of the Dow, the index has never been a total return index. In other words, the price level of the Dow that we see today (roughly 11,000) does not include reinvested dividends. Any idea on what the price level of the Dow would be today if you reinvested dividends back into the index since the index was constructed?

Mark - certainly interested in hearing your take. Again, to me this is a question of how you define market timing. It was absolutely possible to generate over 10% annualized returns from 2000-2010 - I know because I've done backtesting myself. However, this return was generated through a dynamic reweighting process which would increase or decrease stock exposure relative to bonds if certain conditions were met. In other words, to "beat" the stock market, you need to also be invested outside of the stock market during certain junctures.

Oh, and if you're wondering what the Dow would be at today had you reinvested divideds every year since inception, you wouldn't be seeing Dow 11,000...it would be closer to Dow 700,000.

Happy Thanksgiving to All!
Michael A. Gayed, CFA

[Rob Bennett]

"We can say with some level of confidence that markets are overvalued or undervalued, but never by how much with 100% certainty."

I find your comments highly informed and intelligent, Michael. I am grateful to you for being willing to engage in some reasoned and friendly back-and-forth re this important topic.

I agree with just about everything you said in that comment, and certainly with the words quoted above. We CANNOT say with precision how overvalued or undervalued the market is at any particular time. My strongly held view is -- We don't need to!

I'll give you a concrete example of what I am getting at. Most financial planners use a rule of thumb taken from safe withdrawal rate (SWR) studies to advise their clients how to plan their retirements. The studies say that the SWR (the inflation-adjusted percentage that can be taken out of a portfolio each year with virtual certainty that the portfolio will survive at least 30 years) is 4 percent. I say that the methodology used in these studies is analytically invalid, that the numbers generated by the studies are wildly wrong and that the widespread use of and citing of the studies is irresponsible in the extreme.

Why do I say this? It is because the studies do not contain valuation adjustments. I have created the first SWR calculator that DOES contain an adjustment for the valuation level that applies on the day the retirement begins. This calculator shows that the SWR in January 2000 was not 4 percent (a number that would permit a retiree with a portfolio of $1 million to live on $40,000 per year) but 2 percent (permitting $20,000 per year). At times of super-low valuations, the SWR rises to 9 percent (permitting $90,000 per year).

That's not a rounding error. That's a big deal. If we could tell people the accurate numbers, we could provide far more effective retirement planning guidance. But I can tell you what happens when you tell investors about this on discussion boards or blogs. Someone inevitably comes along and says "timing doesn't work." If timing really didn't work, there would be no way to take advantage of all that we have learned as a result of Shiller's finding that valuations affect long-term returns. But one form of timing (long-term timing) DOES work! And we could help people with all sorts of questions if only we could all openly acknowledge this.

It's not just in retirement planning that this is a problem. We cannot give people good guidance on asset allocation if we do not acknowledge that timing works. From 1996 through 2008, the best stock allocation for most middle-class investors was 20 percent or 30 percent. Most experts were telling people to go with a 60 percent or 70 percent stock allocation. If timing doesn't work, 60 or 70 percent makes sense. If it does, then 20 percent or 30 percent makes more sense at those prices.

Part Two Follows Below

[Rob Bennett]

Part Two

I agree 100 percent that we do not know all that we need to know to make perfect decisions. That's all the more reason why we need to get as many people as possible involved in discussions of HOW to time and WHEN to time and HOW MUCH to time. But if people believe the broad claim that "timing doesn't work," none of these sorts of questions ever even come up. When you come to a belief that timing doesn't work, you close the door on consideration of all of the most interesting and important questions in investing analysis. Even many Buy-and-Holders acknowledge that allocation decisions are important. How can one get his allocation call right if he is not looking at valuations when making it (Buy-and-Holders do not do this)?

I get the sense that Buy-and-Holders think of the idea of staying at the same allocation at all times as a safe default position and view changing their allocation in response to big valuation shifts as somehow dangerous. I don't see it that way at all. I would say that a stock allocation that is entirely safe at a time of moderate valuations might be extremely dangerous at a time of high valuations. So the investor cannot possibly get things right unless he at least tries to educate himself on the effect of valuations. But why would someone who believed that timing doesn't work ever bother to do this?

Please understand that I am NOT saying that we have all the answers, Michael. I am saying that we need to begin the work we need to do to uncover the answers and that we cannot even get to first base until we educate investors that at least one form of timing (long-term timing) not only works but is REQUIRED for investors who hope to have any realistic hope of getting their stock allocation right. If you stay with one allocation at all times, you are certain to be going with the wrong allocation somewhere down the road (if you set your allocation to work for times of moderate valuation, you will be wrong when valuations get high, and if you set your allocation to work for times of high valuation, you will be wrong when valuations are moderate).

My main point is that the value proposition of stocks is not a stable thing but something that changes with changes in valuations. To invest effectively, you must be willing to change your allocation from time to time. And to do that, you MUST time the market. If timing really didn't work, we would all be in a big bunch of trouble! We would all be making ineffective asset allocation decisions and down the road suffering failed retirement plans!

Rob

[Rob Bennett]

"From personal experience, short-term market timing works."

I do not personally believe that short-term market timing works, Mark. I just want to say, though, that I have run into a good number of very smart people who believe that I am wrong about this and I certainly believe that it is possible that that is indeed so. I make an effort not to be dogmatic on this point although I of course need to state my own view under my name for so long as I continue to hold it.

Every time someone like you comes along to challenge my view, it does cause me to question it at least a little bit. I am grateful to you for speaking up and causing me to question my own take once again.

Rob

[MBTN]

Rob Bennett:

I have read your posts on this issue, and I appreciate your thoughtful dialogue on the subject. There are a couple things that I wanted to add to the conversation to give you and others some food for thought.

You say that there is "nominal price", which is the true value of the stock factoring out emotions, and that we "know" the true price of the stock at all times. According to finance professors, the price of a stock should be the present value of future earnings. Sounds simple, right. However, there are two unknowns here. First is what will future earnings be? The only way that you can "know" that is if you have a crystal ball. Future earnings are affected by so many factors that are inherently unknowable. The second factor is the discount rate that you use in order to take calculate the present value of future earnings. Again, nobody truly has a crystal ball as to what interest rates are going to look like in the future. Therefore to arrive at the nominal price as you call it is just a wild guess. The stock price is just the consensus of everybody's wild guesses.

Now some of those guesses are going to be clouded by emotion, but some of those guesses will be logical based upon the current information that is available at the time. However, there is so much that can affect a stock price that, unless you are psychic, you won't know in advance.

Take, for example, the fires that occurred in Russia this summer. Those fires had an impact on food production and led to a moratorium on exports for a period of time. That of course drove up the price of many commodities and impacted the future earnings of many companies. Back in the spring, who could have predicted that there would be a drought in Russia which would have that sort of effect. The answer? Nobody did.

This is just one example of events which are beyond our control or knowledge which influence the intrinsic price of a stock.

[Rob Bennett]

"I have read your posts on this issue, and I appreciate your thoughtful dialogue on the subject. There are a couple things that I wanted to add to the conversation to give you and others some food for thought."

Thanks for your kind words and thanks for indeed adding some thoughts that those listening in here very much need to take into consideration, MBTN There's no question (at least in my mind, but I believe that I probably speak for a lot of people re this one) that you are making an important point.

Stock prices can be affected by either rational/economic factors or by irrational/emotional factors. I think we are in agreement re that. And I think we are also in agreement in a belief that we can never know for certain which it is that is having the dominant effect. So we don't know everything that we would like to know.

The question is -- What do we do about this unfortunate reality? There is no neutral ground. We either report the nominal stock price as if it is real (which is what we have been doing during the Buy-and-Hold Era). Or we let people know that there is good reason (but not 100 percent compelling evidence) that the nominal price is heavily affected by emotional inputs. The key message that I want to get across is that THERE IS NO NEUTRAL GROUND. Both of the two possible choices (ignoring the emotional inputs that we believe are there or incorporating the emotional inputs into a price adjustment) carry risks.

Consider the situation in January 2000. The P/E10 valuation metric (the metric used by most of the people who are best informed about valuation questions) indicated that stocks were priced at three times fair value. Say that there is an individual who has a nominal portfolio value of $600,000. If we ignore valuations (which is what we did during the Buy-and-Hold Era), we send him a portfolio statement saying that he possesses $600,000 in stock wealth. If we incorporate a valuation adjustment into our reporting of his stock value, we send him a portfolio statement saying that he possesses $200,000 in stock wealth.

You are right when you say that we do not know with certainty that the true metaphysical value of his portfolio is $200,000. But I am right that we do not know with certainty that the true metaphysical value of his portfolio is $600,000. And getting the number wrong in either direction is going to have horrible consequences for the economy. If you tell someone that he possesses $600,000 in wealth when he really possesses only $200,000, he is going to spend money on houses and cars and vacations that he cannot afford to spend. Then a few years later he is going to regret having overspent for all those years and is going to pull back on his spending and cause an economic crisis. I believe strongly that the crisis we are living through today is the consequence of 30 years of promotion of Buy-and-Hold Investing.

I think that a lot of people experience unease with the thought of putting any number on that portfolio statement other than 600,000. In people's minds, the $600,000 is a hard number while the $200,000 number is just sort of a guess. So people say "it's okay to mention that there might be some overvaluation present, but you have to report the $600,000 number on the portfolio statement." This is where I get off the Buy-and-Hold reservation.

I acknowledge that the $200,000 number is not 100 percent solid. If you asked informed people, some would say a better number is $250,000 and some would say a better number is $150,000. But I really don't think that there is any reasonable person who would say that the best number is $600,000, that there was zero overvaluation present in the market in January 2000. In January 2000 we were reporting numbers that we all knew to be wildly wrong on millions of portfolio statements because we were not as a society willing to look at these difficult questions squarely and come up with REASONABLE AND BALANCED solutions to them.

My claim is not that there is a perfect way to do things and that the Buy-and-Holders won't go along. My claim is that there is a better way than the Buy-and-Hold way and that the Buy-and-Holders are using a demand for absolute 100 percent perfection that they apply only to non-Buy-and-Hold approaches get in the way of consideration of approaches that are better than Buy-and-Hold but something short of perfect. Using $600,000 as the portfolio number was no more "right" than using $200,000 (my personal view is that it was far less right). So why did all of our portfolios use the $600,000 number? Why was there not even a DEBATE about this at the time?

The consequences of avoiding the debate are huge. I discussed above the retirement question. I have a retirement calculator that includes a valuation adjustment. If this debate were proceeding as it should, that calculator would be getting linked at thousands of web sites where people could check it out and DECIDE FOR THEMSElVES whether they want to use valuation-adjusted numbers in planning their retirements or not. The reality is that the calculator is linked at only a tiny number of sites. Not because it does not add something important to the debate. Because Buy-and-Holders feel that it makes them look bad for people to see how far off their numbers turn out to be if a valuation adjustment is employed.

When there is not even a debate about these questions, there is no brake on the car. People have a natural tendency to want to see stocks overvalued -- overvaluation makes for bigger numbers on our portfolio statements and we all want to be prepared for retirement as soon as possible. All humans have an inclination for self-deception and the only thing that can rein this in is a voicing of the dangers. But for so long as we do not permit the debate (because it embarrasses Buy-and-Holders), there can be no voicing of the dangers! And the worse the problem goes, the greater the embarrassment becomes!

We left the market no way to correct prices except through a huge crash. We did that by cutting off the only way that overvaluation steam can be released outside of a crash -- HONEST and REASONED DISCUSSION of the risks of overvaluation. I am proposing a sea change in how investing analysis is performed. I am NOT disputing the point you are making, MBTN. I see it as an important and legitimate point and I consider you a friend for being willing to go to the trouble to advance it here. The sea change that I am proposing is in asking/insisting that in future days the Buy-and-Holders extend that same hand of friendship to Valuation-Informed Indexers, that we all think of each other as friends engaged in a mutual effort to overcome our personal flaws and come to the best overall answers we can come to.

I am biased. I have been invested solely in super-safe asset classes for 14 years. That inevitably biases me against stocks. But the Buy-and-Holders are also inevitably biased in favor of stocks. If we want our boards and blogs to work, we need to acknowledge these biases and make an effort to work together to give ourselves and others the best possible discussions of the issues possible. When all of the people on one side of the table are not participating because it has been made clear to them that their comments will be dismissed as "rude" if they state their honest views, the discussions become misleading and dangerous and irresponsible. None of us really want that. So we all need to make a greater effort to try to put ourselves in the shoes of the other fellow and treat him as we would want to be treated if we held his viewpoint.

That's my strongly held belief re all this, in any event. It is possible that I am wrong on the substance. I am certainly sincere in what I am saying (my record shows this beyond any reasonable doubt whatsoever). Again, I need to say that I am grateful to FMF for providing the forum for this discussion and I offer to do anything that it is in my power to do to see that it proceeds to a good place for every single person involved in it or affected by it.

Rob

[MBTN]

Rob:

Thank you for your response. I think you describe dyour argument quite well. You are saying that just because the "market value" of a basket of stocks is $600,000 doesn't mean that they are actually worth $600,000. I agree with that statement. The actual value (meaning the present value of future earnings) is inherently unknowable. It could be $800,000. It could be $200,000. If it is $800,000 then great; you just made an additional $200,000! If it is $200,000 like you said, then it is a disaster waiting to happen.

I think though that the way you frame the debate between buy-and-hold versus market timing doesn't match with how I see things. Not to say that I am right, just that I see the debate in a different light.

Buy and holder would say that the market value is $600,000 and we don't know if the true value is really $800,000 or $200,000. The market timer would say that the market value is $600,000 but that number is overvalued and the true value is $200,000. From my way of thinking, it is a matter of thinking whether you know what the true value is or not. My opinion is that you can't know the true value because it depends upon future events. That is the way that I see the debate being framed.

I agree with you that there is a risk that the market is overvaluing the value of stocks in which case you are in trouble. However, there is no way for people to know right now whether they are overvalued or undervalued. Yes, if they are overvalued, you are going to take a loss. However if you THINK they are overvalued when in point of fact they are undervalued, you are going to take a loss as well in the sense that you will be selling stocks at $600,000 when they are actually worth $800,000. Either way is a bad condition.

The other thing is that Buy and Holder doesn't mean that you are going to hold 100% in stocks. At least I don't. A buy and holder should realize that he or she doesn't know whether stocks are undervalued or overvalued so he or she will allocate assets across many sectors: stocks (large, small, value, growth, international), bonds (long term, short term, government, corporate, junk), real estate, commodities, etc. The reason being is that usually all of these asset classes move in different directions. When stocks are up, bonds are down. When stocks are down, commodities are up, and so forth. Usually if one asset class is overvalued, another is undervalued. That way, no matter what the unknowable future holds, you will not lose your shirt.

[Rob Bennett]

"From my way of thinking, it is a matter of thinking whether you know what the true value is or not. My opinion is that you can't know the true value because it depends upon future events."

I think you're describing both positions with 100 percent fairness, MBTN. You get right to the heart of the dispute with these words.

If the Buy-and-Holders believed that you could know true value, they would want to know it. You would have to be crazy not to want to know that and just about every Buy-and-Holder that I have met is smart.

And, yes, I believe that you can know true value.

I need to add two caveats for the sake of anyone reading these words who doesn't know about the caveats.

I don't believe that you can know the true value of an individual stock to the same extent that you can know the true value of an index fund. Predicting returns is much more possible now that we have indexes than it was in pre-index days, in my view.

And, two, I don't believe that we can know the true value of even a broad index fund with precision. I believe that we can know enough to invest far more effectively than we could if we did not make the effort to know the true value. But I also believe that we need to be careful not to get too full of ourselves and start thinking that we can know all there is to know.

What I believe is that we can identify a range of possible long-term returns and then assign rough probabilities to each point on the spectrum of possibilities. I think of it like a weather report. When the weatherman says "there is a 70 percent possibility of rain tomorrow," he is giving you useful information. It might rain and it might not and he's not wrong in either event. This is what I do with broad indexes. I look to the historical data and say "there's a 20 percent chance of a 10-year return greater than X and a 60 percent chance of a 10-year return greater than Y and so on."

That's timing, right? That's a form of timing. It certainly doesn't bother me that there are smart and good people who don't believe this works. That's all part of the wonderful game. But I do believe it works and I feel obliged to say that when the subject comes up (which is often!).

This has been one of my favorite threads ever on this topic. I am especially grateful for your comments, MBTN. And for FMF's leadership. But everyone has been great. I hope I have been fair and didn't push too hard. I sometimes push a bit only because I care so much. I do feel respect and affection for those with the other point of view, which I know are numerous and sincere.

Rob

[Tony]

Are you guys finished bouncing off arguments back and forth? OK Now let me tell you the truth. Market timing DOES work, you just need a good timing system to make it work. Does it work for everybody, of course not. There are several systems that have demostrated that timing does work, be it using Relative Strength or a different indicator. I don't think is right for me to tell people where to find this systems because I don't want to sound like a have a vested interest in any of them but they do exist.
If you don't want to invest the time to learn timing strategies you should at least hold a good portion of your portfolio in cash and only buy into the market when valuations are very low (I agree with Rob on this one). A simple 200-day moving average on the S&P can tell you when the market is a decent buy. If you are below this indicator you can buy with more confidence that you are getting a "good price" than when stocks are hitting all-time highs.
Can you detect the absolute bottom and absolute top? no way, but you can get close which for me is good enough, in any case it will be much better than buy and hold.
I have four different investing accounts which follow different strategies: buy & hold with dollar-cost-averaging (this is my 401K), dividend paying ETFS, individual bond ladder, and active trading. My active trading account has consistently outperformed the other three and has also outperformed the S&P for the past 4 years. Of course it's easier to buy a few index funds and let them roll, but easier doesn't mean better in this case.