Much virtual ink is going into articles on whether stock markets are currently overvalued. Let’s suppose you know for certain that they are 25% overvalued. What should you do? The natural answer is to sell all stocks. If we knew the markets were going to have a sudden correction soon to erase the 25% overvaluation, the correct next move would be to sell all stocks and short the markets. Of course, we can’t know this. What if stock markets correct slowly over the next two decades? Suppose that the companies making up the world’s stock markets have business performance that outperforms inflation by 5% per year for the next 20 years. Suppose further that stock prices beat inflation by around 4% per year over that time so that the 25% overvaluation is erased after two decades. Is selling still the right call? The answer to that question is no. If I knew for certain my stocks would beat inflation by about 4% per year for the next 20 years, I’d be thrilled to hold them. It’s ...

In a recent study , market timing based on Robert Shiller’s well-known Cyclically Adjusted Price-to-Earnings ( CAPE ) ratio failed to produce market-beating returns. Here I offer an explanation of why this doesn’t work. Shiller’s CAPE is one way to try to measure whether stocks are currently over- or under-valued. If CAPE gives correct results, you might think it’s self-evident that getting out of the market when stocks are overvalued would be a good idea. Based on this reasoning, the study results seem to imply that CAPE is not a good valuation measure, but this isn’t necessarily correct. Even if CAPE is completely accurate, it still isn’t necessarily useful for market timing. The problem is that it takes time for stock prices to readjust. Suppose that CAPE says prices are 10% too high. If the market reacted quickly, then next year’s returns would be 10% lower than normal. But prices don’t react this quickly. Suppose that it takes 10 years for stock prices to adjust and b...

I’ve argued in the past that trying to time the market is a near impossible game for most of us to win over the long term. This prompted the question “why should we bother trying to do anything like becoming a doctor or a lawyer – there will always be someone else who is better.” It’s certainly true that we can’t reasonably expect to be the very best doctor, lawyer, programmer, or poker player in the world. However, doctors don’t have to compete against every other doctor in the world. It might be tough if the world’s best doctor has the office next door, but under typical circumstances, a doctor merely needs to be in the middling range among his peers to run a successful practice. In the case of a poker player, he just needs to find a game where he is an above average player. The fact that better players exist in the world is of no concern if they aren’t seated at the table. However, when it comes to market timing, you can’t choose your opponent. Equity trading is essential...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. Wouldn’t it be great if you knew when the stock market was going to go down? You could sell your stocks, wait for a while, and buy them back when the stock market was going to rise again. You’d get rich very quickly. Sadly, there doesn’t seem to be any magic way to know when the stock market will go down. You just can’t predict short-term swings in stock prices. But the sting of watching the value of your holdings drop 10% can make it tempting to look for signs of a market decline. Many people actually do a reverse kind of market timing. They get nervous and sell after stock prices drop, and they buy back in after prices start to rise again. Many commentators offer the sound advice that you should keep saving money and ignore short term stock market swings. Suppose that you have taken this advice to heart. Maybe you pour savings into low-MER index...

With the TSX index continuing to rise in recent weeks, only a select few market timers who remain out of the market are in positive territory. Looking at past prices, we can find the day during the stock market downswing that had the same price level as today. I call this the “market timer breakeven date.” The following chart shows what I mean: As prices continue to rise, this date travels further back in time. Apart from a few bumps in the TSX chart, the breakeven date is now back to October 6. Not too many market timers who jumped out of stocks during the downturn managed to do it before this date. Curiously, a few people I know who jumped out of stocks seem quite unconcerned by all this. They are content to wait until “things calm down,” but fail to see the fact that they sold low and are waiting to buy high.

Serious market timers sold completely out of stocks at some point during the recent market crash. Some have bought back in at least partially, but others remain on the sidelines with cash. Since March 9, the TSX composite index has risen 24.7%. This represents between 2 and 3 years worth of average stock markets gains. Stock prices may yet reverse after this recent rally, but what if they don’t? Will the market timers return when the TSX gets to 10,000? If not, then maybe 11,000? No bell is going to ring to let everyone know that the sharks are gone and it’s safe to get back in the water. For every market timer who crows about selling high and buying back in at low prices, I’m betting that there are two or more less talkative market timers who sold low and will ultimately buy back in at higher prices. I’ll stick to my strategy of staying fully invested through the ups and downs.

Market timers often jump out of the stock market when they think it is going down in the hopes of getting back in at lower prices. For this to work, the investor has to get out early enough and back in early enough to avoid selling low and buying high. This brings us to the idea of a “market timer breakeven date.” The following picture illustrates what I mean. Let’s assume for the moment that stocks are now on the rise. A market timer getting back into the market today would have to have sold out of the market before the breakeven date shown in the picture to come out ahead. Any given day we can draw a line over to see the new breakeven date. As stocks rise, the breakeven date moves further into the past sweeping by the exit dates of investors who haven’t jumped back in yet making them losers in the market timing game. Of course, the stock market doesn’t move in a nice smooth curve like the one shown. It jumps up and down mostly unpredictably. Looking at the chart of the TSX, the...

Alice Schroeder’s fascinating biography The Snowball: Warren Buffet and the Business of Life makes it clear that Buffett engages in market timing in the sense that he varies his allocation to stocks over time. If he does it, why shouldn’t we? Of course, Buffett’s market timing is different from the investor who makes short-term bets on whether stocks will go up or down. Buffett looks for attractively-priced stocks, and during some time periods he finds them and sometimes he doesn’t. This is still a form of market timing, though. It’s easy to show that market timers as a whole must make less money than buy-and-hold investors, on average. It’s simple mathematics that the extra trading costs along with investing in inferior asset classes like cash and bonds must hurt the average market timer’s returns. This doesn’t mean that all of them lose to the market averages, though. Buffett is a remarkable example of someone who has beaten the odds so convincingly that he must have talent th...

1. Rogue Clients Falling stock prices mean that financial advisors need to beware of lawsuits from “rogue clients” according to Gowlings’ Ellen Bessner in her interview with the Wealthy Boomer (the web page with this article has disappeared since the time of writing). She defines a rogue client as an investor who claims to have a high capacity for risk but says something different when markets decline. I prefer “insurgent clients” or “terrorist clients” to really drive home the imagery. Perhaps the real reason these clients are angry is because various marketing efforts gave them unrealistic expectations about the advisor’s ability to beat the market and protect their portfolios from loss. Just a thought. 2. Bank Prime Rate The Big Cajun Man added his voice to the many others observing that reductions in the central bank rate are not being fully passed on to borrowers. On one level this makes sense because the banks are recovering from a period where they lent money to borro...

Even after the U.S. government settled on its $700 billion bailout plan, markets continue to drop on Monday. Investors who sold out of the market before this latest drop are congratulating themselves. Unfortunately for them, they still need to make another right guess to come out ahead. Because I don’t believe we’re headed for anarchy, I expect recent stock market losses to reverse sometime in the future. It may not be for months or years, but I expect the sun to shine again. If I’m right about this, then any bears who sold before recent price drops will have to guess when to jump back into stocks. I suspect that most of them will buy back in at a higher price than their selling price. A curious thing about human nature is that many of those investors who end up paying more than their selling price to buy back in will be happy with themselves anyway. Even though they have lost on their market-timing gamble, these investors will cheerfully tell others about how they got out of...

There is no shortage of pundits who offer predictions of what will happen to particular stocks or the stock market in general. You’ll find them on television, radio, and innumerable blogs. I’m open to the possibility that some investors can guess the long-term success of a particular business, but I simply don’t believe any short-term predictions that I hear. Here is why: if these pundits actually get it right a significant fraction of the time, then they could make much more money investing based on their predictions instead of wasting their time as pundits. To prove this, I decided to run some Monte Carlo simulations. Suppose that our pundit Peter predicts whether the S&P 500 will beat inflation each month, and he gets it right 80% of the time. So, 20% of the time when he picks stocks to win, he is wrong, and 20% of the time when he picks inflation to win, he is wrong. This may seem like only a mildly impressive record, but I’ll show how Peter can make himself fabulously wea...

Yesterday I saw the biggest one-day jump in my portfolio value in some time. Days like this are comforting. These gains may drain away in the coming days, but right now it feels good to be fully invested. By “fully invested” I mean that all the money I won’t need for at least 3 years is in the stock market. I only use cash and fixed-income investments for money I will need to spend in less than 3 years (including university costs for both of my sons). Most commentators recommend holding a fraction of your long-term portfolio in bonds so that you won’t panic during market declines. However, market advances outnumber market declines, and I’m more likely to panic if I don’t take full advantage of market advances. Of course, there are worse things than investing a quarter of your retirement funds in bonds. One such bad idea is market timing. There are plenty of people who have pulled their money out of the stock market and are waiting for the right time to get back in. All these peo...

A reader, Jay, left comments on my market timing experiment asking specifically about strategies that buy after a market drop, and sell after the market rises. The theory behind these strategies is to buy low and sell high. I ran some experiments to test this approach. As in previous experiments, the investor decides each month whether to be invested in the S&P 500 or not. The goal is to avoid months where stocks drop in value. I ran the experiments on S&P return data from December 1990 to March 2008. The first thing I tried was to assume that the investor would be invested in the stock market at the beginning and would proceed as follows: 1. If the money is in the stock market, and if stocks are priced at least 5% higher than they were one, two, or three months ago, then sell. Otherwise, stay in the market. 2. If the money is in cash, and if stocks are priced at least 5% lower than they were one, two, or three months ago, then buy stocks. Otherwise, stay out of the mark...

I hope that everyone who read this morning’s version of this post (see below) figured out that it’s an April Fools’ joke. All I did was examine past S&P 500 returns and concoct the silly “zone theory” to exactly pick out which months had negative returns and avoid them. Following this theory really would have returned 28% per year. But, anyone could make money knowing future stock prices in advance. Zone theory was tuned perfectly to past data, and there is no reason to believe that it would work in the future. There is also no reason to believe that you can predict what will happen next month by looking at a stock chart for the past few months. What will happen depends on information that just isn’t in the charts. So, forget about zone theory and other crazy market timing theories and invest for the long term without obsessing on short-term fluctuations. Market Timing Breakthrough! After wasting so much time trying to show that market timing can’t work, I stumbled across an amazin...

In a recent post , I described a market timing experiment where a market timer decides each month whether to own the S&P 500 or to hold all cash. The result was that the market timer had to guess right 60% of the time from December 1990 to March 2008 to keep pace with an investor who simply bought and held through the whole time period. That experiment assumed that the investor was using a tax-sheltered account, as the Canadian Capitalist observed in his comment on that post. What happens if you have to pay taxes on the interest, dividends, and capital gains? I ran the experiment again, this time taking into account taxes. To give the market timer as much help as possible, I assumed that the buy-and-hold investor sells everything at the end of the complete time period and pays capital gains taxes. Tax rates vary from one jurisdiction to the next. For this experiment, I assumed a tax rate of 40% on interest income and 20% on dividends and capital gains. I assume that the marke...

All available evidence and logic tell us that the vast majority of investors can’t beat the market by market timing. This applies to professional money managers as well. I tried a little experiment to see how accurate a market timer’s predictions would have to be to succeed at beating the market. Market timing refers to the practice of jumping in and out of the stock market in an attempt to avoid market declines. The Experiment Suppose that a market timer decides at the beginning of each month whether to have all of his money in the S&P 500 stocks or all of it in cash. His goal is to avoid being in stocks during the months where stocks perform worse than cash. Each month the market timer has a certain probability of guessing right. If he just tosses a coin, this probability is 50%. The question is how high this probability has to be for the market timer to beat the strategy of just buying and holding through thick and thin. I gathered data on the S&P 500 from December...

Bloomberg reports that mutual funds are selling stocks and hoarding cash. Of course, this would have been a better strategy when stocks were at a peak, rather than after they have dropped. This is definitely not a case of better late than never. When it comes to selling stocks in anticipation of dropping prices, I take the approach of better never than late. I just stay invested in stocks through the ups and downs because I don’t believe that I can predict the future direction of the market. It always seems easy to look back and think that what happened was inevitable, but it’s never so easy when you look forward. Mutual funds have a history of selling stocks at market lows and buying in at market highs. We can see this by tracking their cash levels. At market lows mutual funds tend to have high cash levels, and at market highs they tend to have low cash levels according to Larry Swedroe in his book “Rational Investing in Irrational Times.” So, it seems that the professional mone...

ABC stock has been rising steadily lately – is this a good time to buy? XYZ stock has fallen steadily lately – is this a good time to buy? Sadly, the answer in both cases is maybe. It turns out that you just can’t tell what is going to happen to a stock by just looking at what has happened in its price history. ABC might go up and it might go down. The same is true of XYZ. To understand this better, let’s look at an example that is much easier to understand: bananas. Suppose that bananas have been selling for a dollar per pound. Sometimes you buy a few and sometimes you don’t. Suddenly, banana prices jump to $1.50 per pound – should you buy them now? If the bananas seem the same as usual then probably not. But what if the bananas look unusually good, and you ate one and found it to be much better than the usual bananas? Then you’d probably buy them at the higher price. The next month, banana prices drop to 50 cents per pound – should you buy them now? If the bananas seem to be ...

I know I promised a discussion of risk and volatility, but that will have to wait. The stock market is crashing! Shouldn’t we be doing something? Yesterday morning the newspapers and online news sources were nearly unanimous: stocks are headed down and it’s going to be ugly. It can be tempting to sell everything at times like this, and many investors will sell. But if you do sell, when will you jump back in? Maybe you’ll buy once the market rises consistently for a week or two to show that the carnage is over. But this amounts to selling low and buying high. This is the opposite of what you want to do to make money. Any attempt to time the trading of stocks to make more money is called market timing. It can be tempting to try market timing, but be aware that there are others out there who are trying to beat you at this game. Collectively, market timers can’t make more money than those who simply buy and hold their stocks. In fact, on average they have worse results because they...