Recent blog entries have reported on correspondence between a community member named “Larry” and me. Set forth below is the text of an e-mail that I sent to Larry on November 12, 2009.
Larry:
I’m certainly going to look closely at your chart. I’m excited about it.
Just to be clear, we are in complete agreement re the negative reaction that is generated by making claims that timing is a good thing. There are many smart and well-intentioned people who respond as you did. And the reason why they respond that way is rooted in something positive.
Most middle-class people are looking for a way to invest that avoids all the nonsense. The word “timing” is evocative of the nonsense (jumping in and out of stocks each time a new development hits the news). People are looking for something real and the word “timing” evokes all that is phony about investing advice and so they respond negatively to it. That’s a good thing so far as it goes because it suggests that people are open to hearing good ideas that make sense and that work in the long run.
I am today convinced that all of the trouble we have seen has its roots in one grand mistake made by the academics back in the 1960. They saw that short-term timing didn’t work and they felt the need to develop a theory to explain that reality. To understand what happened, you have to put yourself in their shoes and realize how counter-intuitive a reality it was.
Through all of history, people had been trying to employ their intelligence to figure out when to buy stocks and when not to do so. It wouldn’t be overstating things too much to say that the entire investing project was viewed as how best to go about timing the market. And now they had research that showed that timing didn’t work! It was a startling finding and one that simply had to be explained.
There are two possible explanations. One is that the market does such a good job of setting prices that it is impossible for anyone, no matter how smart, to do better. The second is that the market does such a poor job of setting prices in the short term that knowledge is no help in figuring out where prices are going in the short term.
It’s not any more possible to out-guess a lunatic than it is to out-guess a genius. For different reasons. The reason why you cannot out-guess a genius is that he is smarter more than you. The reason why you cannot outguess a lunatic is that his choices defy logic and thus his moves cannot be effectively predicted through the use of logic.
The academics GUESSED that the first explanation was the one that applied. The idea that the market is good at setting prices is the Efficient Market Theory. All of today’s conventional investing wisdom follows from this incorrect guess.
What the data shows is that the reason why short-term timing does not work is that the market is so POOR at setting short-term prices. In the short-term, any connection between the market price and true value is pure coincidence. The market is bonkers in the short term. The price can go to three times fair value or to one-half fair value. The market is the OPPOSITE of efficient in the short-term.
Of course the market IS efficient in the long-term. In five years, a little bit. In 10 years, a good bit. In 20 years, almost entirely. There IS an efficient market. But the market is only GRADUALLY efficient, NOT immediately efficient.
That one error caused all of the strategic recommendations that followed from use of the dominant model to be 100 percent the opposite of what works. If the market does a good job of setting prices, you want to put your trust in the market. If the market is nutso re setting price, you want to come to an independent assessment of fair value (through use of a P/E10 adjustment).
That’s it. That’s the entire problem. The academics took a wrong turn early on and they have never since been willing to retrace their steps. So we keep walking into more and more dangerous territory.
My goal is to get that mistake acknowledged and corrected. Once that is done, there is no problem whatsoever. There will be thousands of people generating good research and good analysis and so on. Things will just naturally get better and better and better.
The hurdle is getting that mistake acknowledged. I think people are afraid to admit the mistake because it is the cornerstone of 30 years of work and they fear tearing everything down at this point. But I see no practical alternative means to getting to a good place. Everything that followed from that big mistake (and that’s just about everything that we “know” about investing today) is wrong. We learn by acknowledging mistakes.
I don’t believe that there is a way around acknowledging the mistake.
The reason why I advocate timing is that I want to steer people toward dealing with this aspect of things. I want to develop a consensus that the old model is broken and that an entirely new model is needed. There is only one difference between the two models. The old model says that timing is impossible and the new model says that timing is required. That one change makes an awfully big difference in the ultimate treatment of hundreds of strategic questions (including asset allocation, to be sure).
We are in complete agreement that this is an asset allocation question. I am saying that it is a lot bigger than that.
It is not just our understanding of how to set our allocations that is wrong. Our entire model for understanding how the market works is wrong. The market is the OPPOSITE of efficient. Think what that means.
I’ll give one example of what I am getting at. Bogle says to tune out the short-term noise. Few of Bogle’s followers really manage to do that. You know why? Because Bogle is saying that the market is setting prices properly. That means that the market’s reaction to events really is of significance and can hardly be ignored by those with money in the market.
I am saying the opposite. I am saying that the market price is pure nonsense in the short term; it is meaningless, insignificant. If people came to believe that, it seems to me that people really could come to tune out the short-term noise in a real and practical way.
Do you see the difference?
It is either true that the market is smarter than the smartest investor alive or that the market is dumber than a bag of rocks. It’s got to be one or the other for short-term timing not to work. It makes a huge difference which of these two things is true. The entire historical record says that the market is dumber than a bag of rocks in the short term and BECOMES smart only after the passage of about 10 years.
I don’t care about the semantics. But I am looking to do more than give people tools for setting their stock allocations. I want people to come to understand how the market works. Once we come to agreement on that, there is no limit to where we can take all this. We have to get it right, of course. What I can say after seven years is that thousands of smart people have tried to find holes in the Rational take and not one has yet been able to come up with any reasoned arguments. I think that’s significant and I want to take this to a bigger stage to see if having more know about it would cause anyone to come up with anything.
If no one is ever able to come up with anything, I think it makes sense to accept what the data says is so as being so: The market is the OPPOSITE of efficient in the short term and always in the process of BECOMING efficient (a process that reaches meaningful fruition at about 10 years).
Rob
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