Wade Pfau: “The Market Timer Enjoys a Far Less Risky Strategy”

It’s not only that Valuation-Informed Indexers have obtained far higher returns that Buy-and-Holders over the entire 140 years of historical data available to us today. Perhaps even more important is that they have done so while taking on dramatically less risk.

Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan (Wade is the fellow who recently posted preliminary research showing that Valuation-Informed Indexing provides better long-term returns than Buy-and-Hold in 102 of the 110 rolling 30-year time-periods in the historical record), advanced a post to the Bogleheads Forum this morning pointing out that the entire historical record shows that long-term market timers (Valuation-Informed Indexers) take on far less risk than Buy-and-Holders.

Set forth below are the words of Wade’s post:

Mel, thank you for the comment. If you think I am trying to be sneaky, I think you are missing something important.In the Fisher and Statman framework, the market timer would have finally returned to 100% stocks in 2009 so that they would have had the same returns that year and would still be together at the end of 2009.

For 2010, I don’t have the market returns data yet, but the PE10 decision rule would have sent the market timer back to Treasury bills. I know stocks outperformed Treasury bills in 2010, and this would hurt the market timer.

Anyway, I just thought that figure was interesting. I know it is not the full story. I hope to have the full story for you in another couple of weeks.

But DP is right that the market timer enjoys a far less risky strategy. I can’t understand why Fisher and Statman glossed over this rather essential detail. They comment that the Sharpe ratio for the market timer is biased upwards because it is comparable to someone with a 50/50 asset allocation rather than a 100/0 allocation. But that suggests to me that we should compare the market timer to a 50/50 allocation instead of a 100/0 allocation. But even without adjusting for risk, the market timer produces more or less the same returns over the whole historical period. That segment of the horserace I showed you began in 1871, not 1995.

And it took the unprecendented 1990s boom for the buy-and-hold guy to catch back up to the market timer. For most of history, the market timer was ahead. Relying on a 100% stocks strategy throughout the 1990s boom doesn’t sound very low-risk to me.