Image from AussieStockForums.com
I believe that the entire Buy-and-Hold Model for understanding how stock investing works was rooted in a mistake. If you want to know the full story, please read this Google Knol that I recently wrote on this topic. For this blog entry, I want to zero in on the key point, the mistake that caused most of the experts to believe things about investing that I feel are not accurate.
Price matters. This is so with everything that you buy. Cars. Sweaters. Comic Books. Bananas. Everything.
But not with stocks, right? The conventional wisdom is that it is okay to stick with the same stock allocation no matter how high-priced stocks can become. If you determine that a 60% stock allocation is right for you, you can stick with that 60% allocation even when stocks are priced at double fair value. Or even when stocks are priced at triple fair value.
Huh? That’s strange, isn’t it? Shouldn’t we be lowering our stock allocations when stock prices get so high that stocks become an exceedingly dangerous investment class? It sure seems that way to me. I think that a lot of people’s common sense tells them that this is so. But they know that the experts think otherwise so they stick to what the experts say, regardless of how accurate their advice happens to be.
Questioning The Efficient Market Theory
In my opinion, the experts have been getting it wrong because of their belief in something called the Efficient Market Theory (EMT). The EMT says that the market always prices stocks properly, or close to it. So there really never is any significant overvaluation. If overvaluation doesn’t exist, then there’s no need to worry about adjusting your allocation when prices get too high.
How did the experts come to believe this? They noticed that short term market timing does not work. Even the most knowledgeable investors are not able to effectively predict where stock prices will be in a year or two.
Trying to explain this, they guessed that the reason for the lack of success of short term online stock trading is the fact that the market is always setting prices properly. If the price is always correct, the market must know everything that matters. So there is no way to gain an edge by knowing something that the market doesn’t know. So timing the market cannot work.
But there’s another possible explanation. The other possible explanation for why short-term timing (and thereby, trying to guess where prices will be in a year or so) would not work is that prices are not efficient at all. What if in the short term, prices are almost entirely the product of investor emotions? If that’s the case, then short term timing and trading the market would not work because there is no way to outguess an entirely emotional process. All the intelligence in the world gives you no edge in trying to anticipate emotional choices.
Why Doesn’t Short Term Trading Work Over Time?
Now here is my analysis of these possibilities: the academic research of recent years shows that valuations affect long-term returns. This would imply that the explanation that the experts settled on is not the right one. If the stock market were efficient, then overvaluation would be a meaningless concept.
So we are left with the second explanation. Short-term timing does not work because stock prices are determined by investor emotions in the short term.
Stock Market Strategy: Market Timing Based On Long Term Views
This leads us to the explanation that long-term timing DOES work. The market MUST set prices properly in the long term. If prices can be wildly wrong in the short term but must be roughly right in the long term, it should be possible to know in advance which way prices are headed (in the long term only, not in the short term) just by knowing the valuation level you are starting from.
Researchers have checked the historical data. This explanation, unlike the EMT-based one, stands up to scrutiny. The same data that taught us that short-term timing never works also teaches us that long-term timing always works. Thus — it turns out that just about everything that the experts have told us about investing in the stock market over the past 30 years is wrong. Oh, my.
I believe that long-term timing works. If you change your stock allocation in response to big changes in prices, you can earn dramatically higher returns while taking on dramatically less risk. Do this throughout your investing lifetime and you can retire five years sooner than you previously thought possible.
The old model for understanding how stock investing works is in the process of collapsing. The new model for understanding how stock investing works is in the process of being built. As investors, we live in exciting times!
If you enjoyed this post, you can get free regular updates through our RSS Feed, or you can have our latest posts delivered to your email inbox by supplying your address here. Your address will only be used for this purpose, and you can unsubscribe anytime.