Wafe Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, has published new research showing that, contrary to the incessant marketing campaigns of The Stock-Selling Industry, market timing always works. That is, those who change their stock allocations in response to big price shifts with the aim of keeping their risk profiles roughly constant obtain far higher returns while taking on greatly reduced risks than do those following widely promoted Buy-and-Hold strategies.
Pfau states: “On a risk- adjusted basis, market-timing strategies provide comparable returns as a 100 percent stocks buy- and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.”
Pfau kindly credits my nine years of work in this field (during which I have argued forcefully that honest posting on safe withdrawal rates and other critically important investment-related topics should be permitted at every investing board and blog on the internet), saying “I am also extremely grateful to Rob Bennett for motivating this topic and contributing his experience and encouragement.”
In a show of his generosity of spirit, he also pays tribute to the leaders of the Bogleheads Forum, who have banned honest discussion of safe withdrawal rates and other important investment-related topics at their site, saying: “Because market-timing strategies are specifically not part of John Bogle’s investment philosophy, the author wishes to thank without implicating users including Adrian Nenu, afan, alec, Alex Frakt, bob90245, cjking, crl848, dmcmahon, DP, grayfox, Les, lostcowboy, market timer, matt, Mel Lindauer, Norbert Schlenker, peter71, pkcrafter, Rodc, SP-diceman, tadamsmar, wearethefall, and yobria.” That sort of comment heals wounds and heaven knows we need wound-healing in the Retire Early and Indexing discussion-board communities today.
The only part that I take issue with is the suggestion (Wade does soften the claim with use of the word “specifically”) that Vanguard Founder John Bogle does not see the merit in long-term market timing. Bogle talks out of both sides of his mouth on this question in nearly every speech he gives. However, the reality remains that Bogle has many times made the case for long-term market timing in clear and compelling terms. I learned about the need to engage in long-term market timing from Bogle’s book and Bogle has said in an interview that he believes Valuation-Informed Indexing can be a good strategy (he did not quite endorse it). It is true, of course, that Bogle often fails to distinguish between short-term market timing (which never works) and long-term market timing (which always works), presumably largely because of the marketing benefits that follow from encouraging investors in their Get Rich Quick fantasies (in fairness to Bogle, I believe that there is a good bit of cognitive dissonance at work here as well).
Pfau explained his purpose in conducting the study in posts he put to the Bogleheads Forum. Stock-selling experts have been telling us for decades that “timing doesn’t work.” And, indeed, many studies have been produced showing that short-term timing (changing your stock allocation because of some expectation of how prices will move in the next year or two) does not work. But how about long-term timing (changing your stock allocation in response to big price shifts with an understanding that doing so may not pay off for as long as 10 years)? Amazingly, Pfau was able to find only one serious study looking at this critically important question. Much of Pfau’s study is aimed at pointing out the flaws in the FIsher and Statman study, which evidenced doubts on the part of the authors about the merits of long-term timing.
It is of course a logical impossibility that long-term timing would not work, given Yale Economics Professor Robert Shiller’s research showing that valuations affect long-term returns. If valuations affect long-term returns, returns should be higher and risks should be reduced at times of low valuations. How could going with a higher stock allocation at times when returns are high and risks are low than one goes with at times when returns are low and risks are high not produce good long-term results? In a rational world, the question Pfau focuses on in his new study would have been analyzed in great depth by many researchers many years ago.
The only explanation for why it has not been is that InvestoWorld is today not generally a rational world. Modern Portfolio Theory (which posits that investors are paid higher returns for taking on more risk, the opposite of what logic says must often be the case if valuations affect long-term returns) has influenced our thinking to such an extent that we do not even know to research the most important questions facing us. As World-Renowned Portfolio Strategist Bob Dylan pointed out in his Idiot Wind Theory (a popular counter to the excessively rationalistic Modern Portfolio Theory), “we’re idiots, babe, it’s a wonder we can even feed ourselves.”
This does indeed appear to be the case. At least that’s what the 140 years of historical data available today for our inspection reveal to the researcher willing to listen to its Forbidden Message.
Pfau charts the nominal wealth accumulation of $1 invested at the start of 1871. The Buy-and-Hold strategy examined is a 100 percent S&P 500 portfolio. The baseline market timing strategy chooses either 100 percent stocks or 100 percent Treasury bills at the start of each year, depending on whether the value of P/E10 is below or above it’s historical average at that time.
The Buy-and-Hold portfolio was worth $95,404 at the end of 139 years. The Valuation-Informed Indexing portfolio was worth $124,147.
Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”
Noting that the Valuation-Informed Indexing portfolio is able to generate the same returns as the Buy-and-Hold portfolio while being out of stocks half of the time and thus putting itself at what should be a huge disadvantage according to Modern Portfolio Theory, Pfau also compares the Valuation-Informed Indexing portfolio, which has an average stock allocation of 50 percent, with a 50 percent Buy-and-Hold portfolio. In this case, the risks of the two portfolios are roughly equal but the returns for the Valuation-Informed Indexing portfolio are dramatically superior. The Buy-and-Hold portfolio has an end-point (2010) value of $13,426. The Valuation-Informed Indexing portfolio has an end-point value of $94,866.
The study concludes: “Valuation-based market timing with PE10 has the potential to improve risk-adjusted returns for conservative long-term investors.”
Truly amazing stuff!
We’re idiots, babe. But I think it would be fair to say that those who read this study and spend some time thinking through the implications that follow from it are perhaps a bit less idiots than they were on the day before they took that promising step into the light. Thank you, Wade Pfau!
Please find some room for reporting on this fellow’s work on your front page, New York Times editors! By the close of business today if at all possible!