- Even the most rational index investors
might catch themselves wondering
if they should sell some of their equities,
or delay investing new cash
because of expected market volatility,
or reports of record high stock prices.
And if the market does happen to drop,
our brains will allow us to believe that we were right,
which might increase the future impulse to time the market.
That is called confirmation bias.
It is not a good way to make financial decisions.
Instead, we should look at the data on market timing
to see if it is a viable strategy.
I am Ben Felix portfolio manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you what the data say about market timing.
(bright music)
Before I get into the episode,
I wanted to take a moment to thank all of you
for watching and subscribing.
I didn't really know what to expect
when I started making these videos two years ago,
but the response has been excellent
and it feels like there's a great community
building around the channel.
One of the biggest challenges
in thinking about timing the market
is that there is actually data showing
that when markets are expensive,
future returns tend to be lower.
This might make it seem obvious
that if stock prices are high relative to the past,
it might not be a good time to be in the market,
or at least not a good time to invest new money.
The most reliable metric that we have
for forecasting future returns
is the Shiller CAPE or a cyclically adjusted price earnings.
If we look at market history, periods of high prices
have often been followed by lower returns.
Take a look at the annualized excess returns for stocks
that have been sorted quarterly based on valuations
using the Shiller CAPE.
This chart is from an AQR paper
titled "Market Timing, Sin a Little."
On the left we can see that the bucket
of the most expensive stocks
has a substantially lower return
than the bucket of the least expensive stocks on the right.
There is clearly a relationship between current valuation
and future returns.
Well it may seem like I'm making argument
in favor of market timing, I can assure you that I'm not.
One problem here is that the data that we just saw
has a meaningful hindsight bias built into it.
Think about it.
If we sort stocks every quarter,
based on their valuation relative
to all of the history that we were examining,
we are cheating.
A real investor would not know
what feature evaluations are going to be,
which would make their evaluation based
sort far less effective.
Stocks may look expensive relative to history today,
but relative to the future, which we can observe,
they may look cheap.
This causes an obvious problem for market timers.
In the same AQR paper.
They adjust for this hindsight bias
by sorting stocks at quarterly,
based on only the past 60 years of data ending each quarter.
With this method, we are getting results
that are real investor may actually be able to capture.
The results in this case are much weaker.
There is still a trend toward lower return
when stocks are most expensive,
but it is much less obvious
than in the case of perfect foresight.
Even though it's weak, there is still a relationship.
When stocks are expensive relative to the past,
future returns tend to be lower.
The real question though
is whether or not you can use this information
to make investment decisions.
The AQR paper also asked this question.
They built a market timing strategy
that adjusted the weight in stocks based on valuations.
They tested the strategy on data from 1900 through 2015.
For the full sample,
the timing strategy did add value to returns,
but it underperformed from 1958 through 2015.
The author suggests that this may be due
to stocks becoming more or less cheap
for very long periods of time.
In other words, from 1900 through 1957,
stocks were generally cheap relative to their past resulting
in the timing strategy being more than 100% invested
in stocks due to leverage for most of the time period.
From 1958 through 2015,
stocks were generally expensive relative to the past,
resulting in the strategy being under-invested
for most of the time period.
The paper sums this up as follows.
"Valuations can drift higher or lower
for years or decades making it difficult
to categorize the current market confidently as cheap
or expensive without hindsight calibration,
and therefore difficult to profit
from such categorizations."
One of the other challenges
with using signals like the Shiller CAPE to time the market
is that even after a signal may suggest
that lower returns are coming,
there may still be more high returns to come.
There is evidence that when stocks have been increasing
in price, they tend to continue
on that trajectory for some time.
This is known intuitively as momentum.
Stocks will start to look expensive
based on metrics like the Shiller CAPE,
because they've been going up in price.
Selling them at that point
means that you are betting against momentum,
which is a well-documented phenomenon.
We also have to remember that most of the market's returns
come in a relatively small number of trading days.
Take a look at this data for the S&P/TSX composite index.
From 1977 through 2018, the index returned 9.72%.
If you missed the single best trading day
over that full time period,
the annualized return drops to 9.48%.
If you missed the 15 best days,
the annualized return drops to 7.44%.
That's more than a 2% drop in annualized returns
for missing a tiny fraction of the total trading days.
Now, the probability of missing the 15 best days
may not be any better than the probability
of missing the worst 15 days.
So this is an extreme example,
but the point is that you have to stay in the market
if you want to get the market's returns.
I think that even for the most rational investors,
the urge to market time will be the strongest
when there is a lump sum of cash to invest.
It's scary looking at your pile of cash
and knowing that it could drop substantially
the day after you invest it,
especially when there is so much uncertainty in the market.
Let me tell you something that I've learned
after having hundreds of conversations like this.
The market always feels uncertain.
Feelings of uncertainty are not basis
for market timing decisions.
One simple trick that many people are familiar with
to alleviate such concerns is dollar cost averaging.
Instead of investing $100,000 today,
you invest $10,000 per month over the next 10 months.
This alleviates any concerns over investing
at the worst possible time.
But unfortunately that is all that it does.
Dollar cost averaging is systematic which is good,
but at the end of the day,
it is still a form of market timing.
Dollar cost averaging should not on average
give you a better result
than investing your lump sum of cash right now.
Vanguard study this in a 2012 paper
titled "Dollar Cost Averaging Just Means Taking Risk Later."
They tested lump sum investing against dollar cost averaging
over 12 month periods from 1926 through 2011 in the U.S,
1976 through 2011 in the UK.
And from 1984, through 2011 in Australia.
They found across stocks, bonds,
and a 60/40 balanced portfolio
in all geographic regions tested,
lump sum investing beat dollar cost averaging
roughly two thirds of the time.
As we have seen, there is a relationship
between current market valuations observed
by the Shiller P/E and expected future returns.
As tempting as this seems,
that relation and ship is not reliable enough
to provide any meaningful information
for investment decision-making.
Before anyone tells me
that they would base their market timing decision
on intuition as opposed
to evaluation metric like the Shiller P/E,
let me tell you what Nobel Laureate Denny Conaman
told the 71st CFA Institute Annual Conference.
"It is very difficult to imagine
from the psychological analysis of what expertise is
that you can develop a true expertise in say,
predicting the stock market.
You cannot because the world isn't sufficiently regular
for people to learn rules."
Market timing is hard.
You have to get out at the right time,
which is hard to do even
with the most reliable forecasting metrics
that we have available.
And then you have to get back in at the right time.
Even if you missed the right time by a few good days
in the market, you can seriously hurt your longterm returns.
I haven't even talked about the trading costs
and taxes incurred to jump in and out of the market,
which depending on the circumstances
could have a large negative impact on returns.
John Bogle, Vanguard's legendary founder
famously said about market timing;
"after nearly 50 years in the business,
I do not know of anybody who has done it successfully
and consistently.
I don't even know of anybody who knows anybody,
who has done it successfully and consistently"
If you are sitting on cash to invest and feeling nervous,
I think that dollar cost averaging,
well, statistically suboptimal and a form of market timing
is much better than sitting on the sidelines waiting
for the perfect moment.
Have you ever caught yourself timing the market?
Tell me about it in the comments. Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone who you think could benefit
from the information.
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of the Rational Reminder podcast,
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(upbeat music)