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The perils of timing the market


Liberty
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Thanks, great read.

 

+1

 

I think almost all value investors recognize that market timing doesn't work, yet they seem to do it with their cash positions all the time. Decreeing that 15% of your portfolio should be in cash, for example, because the market looks frothy is still market timing.

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Thanks, great read.

 

+1

 

I think almost all value investors recognize that market timing doesn't work, yet they seem to do it with their cash positions all the time. Decreeing that 15% of your portfolio should be in cash, for example, because the market looks frothy is still market timing.

 

But that's what Benjamin Graham talks about a lot: allocating bond/stock mix, the stocks should get a lower allocation when the market PE 's are high..... I don't think considering market valuations is market timing, you may also not be able to find good stocks in those times which also results in less stock allocation.

 

 

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Thanks, great read.

 

+1

 

I think almost all value investors recognize that market timing doesn't work, yet they seem to do it with their cash positions all the time. Decreeing that 15% of your portfolio should be in cash, for example, because the market looks frothy is still market timing.

 

If you hold a certain amount of cash simply because of what you think about the market, then that is probably market-timing. 

 

If a bottoms-up approach isn't able to find many investments that are safe and cheap then you should hold cash.  And many people probably are holding cash now because of this. 

 

Also, it's important to consider opportunity costs.  Both opportunity costs of not being invested, and opportunity costs of not having cash when you wish you did have it.  The opportunity cost of holding cash rather than investments is fairly low now, because rates are low and valuations are fairly high.  So I don't believe you are losing out on much by holding cash now.  And "opportunity cost" has to be thought of separately from short-term market return; sure, you could have bought stock in a mediocre company at a mediocre valuation in the past year, and it is probably up 50% in 6 months, but I am talking about long-term expected returns. 

 

And on the flipside, there is the opportunity cost of not having cash when you want it, which has to be considered when you are thinking about the opportunity costs of holding cash.  Or, another way of saying this is Munger's adage that "it's the waiting around that is important."

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But that's what Benjamin Graham talks about a lot: allocating bond/stock mix, the stocks should get a lower allocation when the market PE 's are high..... I don't think considering market valuations is market timing, you may also not be able to find good stocks in those times which also results in less stock allocation.

 

You only consider it to be market timing if it doesn't involve fundamental analysis? I can see why you would define it that way but I don't think that's the widely accepted definition.

 

From Wikipedia: "Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis"

 

As talked about in the original article, The Prudent Bear Fund was managed in accordance with market valuation and their timing strategy has been a disaster. The thing is, not even Ben Graham's market valuation/timing techniques were reliable, if I remember correctly. Prices can look high and stay high while fundamentals catch up, interest rates can continue to drop thereby increasing multiples, etc. I think this is why it's recommended that you choose a given stock/bond allocation and rebalance to maintain the ratio rather than try to pick your own ratios based on what you think each asset class will do.

 

If pulling 100% of your portfolio out of the market because you think the valuation is too high is considered market timing why is doing the same thing with a lesser percent any different? It's the same principle. The reasoning, purpose, and outcome of both decisions are the same.

 

As you said, if you have an absolute standard you'll find fewer investments that clear your hurdle as the market goes higher naturally building a cash position. Or maybe the more important implication for us folks with small portfolios is that we should always be invested since we can almost always find opportunities. Buffett's 'retirement' in 1969 was on account of him being unable to find good investments.

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But that's what Benjamin Graham talks about a lot: allocating bond/stock mix, the stocks should get a lower allocation when the market PE 's are high..... I don't think considering market valuations is market timing, you may also not be able to find good stocks in those times which also results in less stock allocation.

 

You only consider it to be market timing if it doesn't involve fundamental analysis? I can see why you would define it that way but I don't think that's the widely accepted definition.

 

From Wikipedia: "Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis"

 

As talked about in the original article, The Prudent Bear Fund was managed in accordance with market valuation and their timing strategy has been a disaster. The thing is, not even Ben Graham's market valuation/timing techniques were reliable, if I remember correctly. Prices can look high and stay high while fundamentals catch up, interest rates can continue to drop thereby increasing multiples, etc. I think this is why it's recommended that you choose a given stock/bond allocation and rebalance to maintain the ratio rather than try to pick your own ratios based on what you think each asset class will do.

 

If pulling 100% of your portfolio out of the market because you think the valuation is too high is considered market timing why is doing the same thing with a lesser percent any different? It's the same principle. The reasoning, purpose, and outcome of both decisions are the same.

 

As you said, if you have an absolute standard you'll find fewer investments that clear your hurdle as the market goes higher naturally building a cash position. Or maybe the more important implication for us folks with small portfolios is that we should always be invested since we can almost always find opportunities. Buffett's 'retirement' in 1969 was on account of him being unable to find good investments.

But that's what Benjamin Graham talks about a lot: allocating bond/stock mix, the stocks should get a lower allocation when the market PE 's are high..... I don't think considering market valuations is market timing, you may also not be able to find good stocks in those times which also results in less stock allocation.

 

You only consider it to be market timing if it doesn't involve fundamental analysis? I can see why you would define it that way but I don't think that's the widely accepted definition.

 

From Wikipedia: "Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis"

 

As talked about in the original article, The Prudent Bear Fund was managed in accordance with market valuation and their timing strategy has been a disaster. The thing is, not even Ben Graham's market valuation/timing techniques were reliable, if I remember correctly. Prices can look high and stay high while fundamentals catch up, interest rates can continue to drop thereby increasing multiples, etc. I think this is why it's recommended that you choose a given stock/bond allocation and rebalance to maintain the ratio rather than try to pick your own ratios based on what you think each asset class will do.

 

If pulling 100% of your portfolio out of the market because you think the valuation is too high is considered market timing why is doing the same thing with a lesser percent any different? It's the same principle. The reasoning, purpose, and outcome of both decisions are the same.

 

As you said, if you have an absolute standard you'll find fewer investments that clear your hurdle as the market goes higher naturally building a cash position. Or maybe the more important implication for us folks with small portfolios is that we should always be invested since we can almost always find opportunities. Buffett's 'retirement' in 1969 was on account of him being unable to find good investments.

 

 

So you are saying what Buffett did is not market timing then?  The right strategy for the future is unknowable, but you are saying most value investors know this doesn't work. I dunno, I can't be sure .....

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it just seems that worrying about wether or not you time the market is counterproductive.

 

Just try to find those cigar butts with like 20-25% cash flow yields, or find companies with very nice moats for a 10% earnings yield.

 

If you cannot find those, just dont invest, and if you do find enough of those, you should be fully invested.

 

Your goal is not to be invested, so dont loosen standards when the market goes up.

 

The upside is that if you do find those cheap ideas in a bull market, they go up much more quickly to fair value. So your returns will be higher because it takes less time.

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There's no performance benefit from ideological purity, i.e. "Market timing is bad and never works".

 

Lots of investing strategies work sometimes and fail sometimes. Market timing is no exception.

 

 

You can certainly see in hindsight that it worked for some, but can you use it looking forward and win more than you lose? I think that's the crux of the matter.

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There's no performance benefit from ideological purity, i.e. "Market timing is bad and never works".

 

Lots of investing strategies work sometimes and fail sometimes. Market timing is no exception.

 

There is a difference between not working ie not beating the market and not making money at all or losing money. Market timing is nothing that sometimes work and sometimes not, it depends on you if it works AND you make money of it. And when you do it, you are not an investor anymore but a trader. And a trader has to admit that he is sometimes wrong and correct his path. When he doesn`t do it, he usually ruins his account. 95% of all traders lose money in the market, but everybody thinks he belongs to the 5%. I was no different :). Read "Reminiscences of a Stock Operator", than you get a really cool look at how market timing can work. But be aware that even the genius Livermore was more than one time broke.

 

Holding cash because you can`t find investments anymore can in my eyes only happen for a money manager that is bound to restrictions like only us stocks and/or managing huge amounts of money. For everybody else its probably not enough time spend searching or the circle of competence is too small. (But even then you can coattail other investors.)

 

But i respect when somebody holds cash to reduce volatility, because in the end thats what it does.

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valueinvestors always love to say that you can only  make money with the value aproach in the markets. But i do think there are a few people who are killing it with other methods over longer periods of time. It just is harder. Even Munger agrees with me here. I think that is one of the few things buffet and munger actually disagree over.

 

I mean the 95% figure doesn't say anything. I used to play poker, and there almost everyone breaks even or loses money. But it is a skill game, and it is very much possible to win money with it over the long run. All it says is that alot of people are just idiots or cant be bothered to put in the work.

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There's no performance benefit from ideological purity, i.e. "Market timing is bad and never works".

 

Lots of investing strategies work sometimes and fail sometimes. Market timing is no exception.

 

 

You can certainly see in hindsight that it worked for some, but can you use it looking forward and win more than you lose? I think that's the crux of the matter.

 

Quite true. There are studies showing market timing strategies that worked. Whether you think they will continue to work is a judgement call.

 

http://www.kc.frb.org/publicat/reswkpap/pdf/rwp02-01.pdf

http://wpfau.blogspot.com/2011/01/valuation-informed-indexing-preliminary.html

http://mpra.ub.uni-muenchen.de/35006/

http://philosophicaleconomics.wordpress.com/2013/12/20/the-single-greatest-predictor-of-future-stock-market-returns/

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2302218

http://www.frankfurt-school.de/clicnetclm/fileDownload.do?goid=000000311260AB4

http://www.marketwatch.com/story/wisdom-of-richard-fabians-system-emerges-in-hindsight

http://www.marketwatch.com/story/maybe-the-best-market-timing-system-ever-2011-07-12

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Liberty, thanks for posting.

 

It was an okay read but it screams hindsight bias. Yeah, the bears strategies didn't work during one of the biggest bull markets during history. What if this were written in like 1982 or something?

 

On another note, I was looking at SPY just now. Let's say you bought it on 10/31/2007. It has annualized 3.27% as of yesterday. Add it another 2.5%-3% dividend average over those years and you're looking at roughly a 6% return.  If we also factor how little inflation has impacted us over the years (gas is lower as are home costs), in real terms we're probably at like 5% at least if not higher (assuming 1% inflation). The real return is usually 7% (over decades; 10% market return - 3% inflation)

 

We go through, allegedly, the worst recession since the Great Depression and 6.5 years from the height would have only underperformed market averages, in real terms by about 2%. That, after going through the biggest bull market in history, too, mind you. Does anyone else strike it as odd that we're not really paying for our mistakes? Didn't it take us like 25 years (not including inflation) to get back to the same level of the market after the Great Depression? Not only have we returned back to the all-time highs, we are actually ahead pretty nicely, given the circumstance - not actually doing significantly worse than historical averages.

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Liberty, thanks for posting.

 

It was an okay read but it screams hindsight bias. Yeah, the bears strategies didn't work during one of the biggest bull markets during history. What if this were written in like 1982 or something?

 

Hi Stahleyp,

 

That's a good point, but at the same time, hindisght bias can go both ways and picking particularly bad periods might not tell us more.

 

Looking back 30 years seems fairly statistically significant, especially since as you pointed out this period includes the GFC as well as the dot-com bust and various other smaller recessions. 30 years is pretty much my whole life (I'm 31), so while it's not going back to the civil war, it's also not like going back just 5 years..

 

If you go back 30 years from 1982, this probably look different than if you just take a bad decade like the 70s.

 

I also think the future will probably be more similar to the past 30 years than to the 30 years before that, or the 30 years before that... just because the economy isn't a static thing. If a large portion of the economy is now services, software, pharma and other asset-light, IP-heavy stuff, globalized multinationals, etc, it is bound to have had an impact on things like profit margins, cyclicality, and various other trends (which I can't pretend to understand or predict, but I just know that the past 30 years are more similar to present day in many ways than 1900-1930, for example).

 

On another note, I was looking at SPY just now. Let's say you bought it on 10/31/2007. It has annualized 3.27% as of yesterday. Add it another 2.5%-3% dividend average over those years and you're looking at roughly a 6% return.  If we also factor how little inflation has impacted us over the years (gas is lower as are home costs), in real terms we're probably at like 5% at least if not higher (assuming 1% inflation). The real return is usually 7% (over decades; 10% market return - 3% inflation)

 

We go through, allegedly, the worst recession since the Great Depression and 6.5 years from the height would have only underperformed market averages, in real terms by about 2%. That, after going through the biggest bull market in history, too, mind you. Does anyone else strike it as odd that we're not really paying for our mistakes? Didn't it take us like 25 years (not including inflation) to get back to the same level of the market after the Great Depression? Not only have we returned back to the all-time highs, we are actually ahead pretty nicely, given the circumstance - not actually doing significantly worse than historical averages.

 

I think we must be careful to separate business fundamentals from morals. Should we repent or not for some mistakes isn't relevant if fundamentals are doing ok and getting better.

 

It's also important to remember that in 2008-2009, we didn't go through the Great Depression. We avoided it. We had huge liquidity problems and we were on the brink and lots of things went really badly, but we didn't get 25% unemployment and global protectionism and fascist dictators rising and a huge part of the world economy splitting off into communism and such. When comparing, we must look at the differences too, not just the similarities.

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valueinvestors always love to say that you can only  make money with the value aproach in the markets. But i do think there are a few people who are killing it with other methods over longer periods of time. It just is harder. Even Munger agrees with me here. I think that is one of the few things buffet and munger actually disagree over.

 

I mean the 95% figure doesn't say anything. I used to play poker, and there almost everyone breaks even or loses money. But it is a skill game, and it is very much possible to win money with it over the long run. All it says is that alot of people are just idiots or cant be bothered to put in the work.

 

Jack Schwager has written a really good book about successful traders (Market wizards). There are plenty of ways to make money in the market and i would never say theres only value investing. But value investing is the simplest one, its the one that nearly everybody can manage to do. And if you are bad you are probably not beating the market, but there is a good chance you are still making money. The most other methods have a high entry hurdle because its very hard to break even. One mistake and you are often back to zero. I read about successful option sellers (>30% per year even in 2008), successful penny stock daytraders (from 1500$->1.7million$ in 3 years.) and successful technical traders. But for all these methods you are the factor that determines if you are successful or not. And that only works when you have lots of discipline and are in full control of your emotions. You have to permanently work on yourself. And everyone was able to admit that he/she is sometimes wrong and correct themselfs in some way.

 

And value investing has another "advantage", because nearly every other successful method requires you to sit in front of the computer as long as the market/your position is open. I tried this for some time but working 8 hours a day and than 8 hours as a trader was not working. Perhaps i try that again when i am retired.

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So you are saying what Buffett did is not market timing then?  The right strategy for the future is unknowable, but you are saying most value investors know this doesn't work. I dunno, I can't be sure .....

 

I think the follow up article shows that what Buffett did was not market timing and that he had an absolute standard that caused him to stay fully invested when he could find opportunities.

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-1-partnership.html

 

There's no performance benefit from ideological purity, i.e. "Market timing is bad and never works".

 

Lots of investing strategies work sometimes and fail sometimes. Market timing is no exception.

 

The way you use the term ideological purity makes it sound like a bad thing. It's definitely not a bad thing to believe in principles and follow them. When Buffett refused to invest in dot com stocks he was being ideologically pure even though the value strategy was not producing results. Yet in the long run he absolutely did get a performance benefit from being principled.

 

There are all sorts of principles that don't provide immediate benefits when you follow them. Stealing is a good example. Robbing a bank can give you short term satisfaction in certain circumstances (like when you get away scot-free) but is disastrous as a strategy for your long-term self interest. There are also times when momentum strategies work and value investing doesn't work but those are the times you need to be the most 'ideologically pure.' I just don't agree that there's no performance benefit from being a principled value investor. The point of value investing is that it is timeless and applicable across all geographies because it is logically derived from the very meaning of what investing is- hence Munger's quote, 'all intelligent investing is value investing.' Even if there are some instances of people timing the market successfully, the fact is that it's dangerous for 99.9% of people to try.

 

If you think you can switch from strategy to strategy based on what's working at the time... best of luck to you. Try living your life that way and see how THAT turns out!

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This summary of letters is really great and highlights one point which is critically in my eyes. You have to be able to put an expected rate of return number on every investment you can possibly make and choose the ones which offer the best returns. It looks so simple but i have only seen a handful of people doing this and i think this is the key factor to ignore macro and every other noise.

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Liberty, thanks for posting.

 

It was an okay read but it screams hindsight bias. Yeah, the bears strategies didn't work during one of the biggest bull markets during history. What if this were written in like 1982 or something?

 

Hi Stahleyp,

 

That's a good point, but at the same time, hindisght bias can go both ways and picking particularly bad periods might not tell us more.

 

Looking back 30 years seems fairly statistically significant, especially since as you pointed out this period includes the GFC as well as the dot-com bust and various other smaller recessions. 30 years is pretty much my whole life (I'm 31), so while it's not going back to the civil war, it's also not like going back just 5 years..

 

If you go back 30 years from 1982, this probably look different than if you just take a bad decade like the 70s.

 

I also think the future will probably be more similar to the past 30 years than to the 30 years before that, or the 30 years before that... just because the economy isn't a static thing. If a large portion of the economy is now services, software, pharma and other asset-light, IP-heavy stuff, globalized multinationals, etc, it is bound to have had an impact on things like profit margins, cyclicality, and various other trends (which I can't pretend to understand or predict, but I just know that the past 30 years are more similar to present day in many ways than 1900-1930, for example).

 

On another note, I was looking at SPY just now. Let's say you bought it on 10/31/2007. It has annualized 3.27% as of yesterday. Add it another 2.5%-3% dividend average over those years and you're looking at roughly a 6% return.  If we also factor how little inflation has impacted us over the years (gas is lower as are home costs), in real terms we're probably at like 5% at least if not higher (assuming 1% inflation). The real return is usually 7% (over decades; 10% market return - 3% inflation)

 

We go through, allegedly, the worst recession since the Great Depression and 6.5 years from the height would have only underperformed market averages, in real terms by about 2%. That, after going through the biggest bull market in history, too, mind you. Does anyone else strike it as odd that we're not really paying for our mistakes? Didn't it take us like 25 years (not including inflation) to get back to the same level of the market after the Great Depression? Not only have we returned back to the all-time highs, we are actually ahead pretty nicely, given the circumstance - not actually doing significantly worse than historical averages.

 

I think we must be careful to separate business fundamentals from morals. Should we repent or not for some mistakes isn't relevant if fundamentals are doing ok and getting better.

 

It's also important to remember that in 2008-2009, we didn't go through the Great Depression. We avoided it. We had huge liquidity problems and we were on the brink and lots of things went really badly, but we didn't get 25% unemployment and global protectionism and fascist dictators rising and a huge part of the world economy splitting off into communism and such. When comparing, we must look at the differences too, not just the similarities.

 

I agree that the economy isn't static. However, Klarman states (and I believe him) that in economics there is no free lunch. If we really are through the worst part and all we had to do is knock 2% off of real returns for a few years - that's more or less a free lunch (or a deeply, deeply discounted one). Also, I think it's an error to only look at 30 years of market history. That's what got us into trouble with the subprime crisis, from my understanding. People were only looking at data that was like 50 year old (maybe 30 year old data?) or so and thought "housing, nationwide, has never lost money". We'll build our models around that.

 

From 1979-1999 we compounded at almost 18% a year on the s&p 500. The long term returns before that was 9% in 1979 (now it's about 10%). The past 15 years is at about 4.6% and that still has us with above average long term returns (10% vs 9%). Even after the middling (but still inflation beating growth) we're still above long term returns. So, we had all this excess, all this waste and we're still doing better? The 25 year return as of the end of 2013 is 10.26%. Even after the past 15 years we are still above the long term returns of 10% (slightly) and a bit above the pre-1980s bull market of 9%.

 

It took us like 25 years (not including dividends) to get through the Great Depression (from peak to peak) and now we are off to the races again after like 5 years or so for a period that was worse than the 70s (allegedly)? I'm not even talking about inflation adjust numbers with the Great Depression - this is just nominal values on the index.

 

It might be true. But to me, at least, it sounds too good to be true. Are we that much smarter than our great grandparents as far as the art/science of economics go that we can have plenty of excess and still have better returns? Perhaps, but perhaps not. I'm still in the game but frankly, I've toned down my aggressiveness a bit.

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The epicenter of that crisis was housing, and that part of the economy did go through a depression (in Buffett's words) and will take some years to get out of it and back to where it was:

 

http://www.economist.com/blogs/graphicdetail/2014/02/us-house-prices

 

My understanding is that on the stock market side, it's not like we suddenly realized that almost everything was worthless (like the NASDAQ after the dot-com bubble), but rather that liquidity froze and for a while nobody knew if they could meet their obligations and had to try to sell assets are fire-sale prices to raise cash. Re-injecting cash in the system did help because that was a big part of the problem. Injecting cash in the dot-com bubble would've been pointless.

 

So you looking at the SP500 to see the fallout might be missing part of the story. Look at housing, and at the value of many financials now compared to 2006, and you'll see that the crisis left deep scars (though not everywhere as deep).

 

From what I know, the Great Depression had quite a different effect on the 'real' economy than the 2008-2009 crisis and the reaction by governments was also very different (I've alluded to some aspects in a post above), and so it's not surprising that the recovery to both looks different.

 

Just my 2 cents, though, I could be wrong.

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Liberty, thanks for the thoughtful post.

 

I might be wrong, too. I'm thinking that China's real estate market could possibly be a tipping point.

 

I'm a pretty simple guy though and I try to follow the old rule to be fearful when others are greedy and be greedy when others are fearful. We're not yet on to full greed (hence why I'm still mostly invested but have been paring back) but we're swinging closer as the rally continues. My uncle, who sold out a while ago is thinking about getting back in because he felt that he missed out. We shall see. Good luck (for both of us!).

 

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