Stock Investors Overstate Their Gains In The Heat Of Bull Markets

Summary

• We buy more stocks when prices are high and long-term returns are low because stocks possess more emotional appeal at such times.
• I advocate that investors increase their stock allocation to 90 percent at times of super-low valuations and decrease it to 30 percent at times of super-high valuations.
• Investors who practice price discipline/market timing beat the average by investing more heavily in stocks at the times when their going-forward return is likely to be higher.

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Original Post

By Rob Bennett

Most investors know the average long-term return for stocks. It is 6.5 percent real. That’s of course a very good return. That’s a high enough return to permit most middle-class people to finance a decent retirement by the time they turn 65. We should be happy with it.

Practicing Market Timing

If we were happy with it, we would all practice market timing. When returns got much higher than that for a number of years in a row, we would understand that the extra returns were not real but just the product of irrational exuberance, and we would not count on those gains in the same manner as we treated the gains that were the product of economic growth. But of course, most of us follow Buy-and-Hold strategies. We treat all gains as equally real and we disdain market timing.

That means that most of us don’t really earn that average 6.5 percent real return. We buy more stocks when prices are high and long-term returns are low because stocks possess more emotional appeal at such times. Instead of buying more stocks when prices are good (that would be timing!), we buy more stocks when prices are bad and thereby pull our personal return below the average return. If there’s a benefit to practicing price discipline (there must be!), there’s clearly also a detriment to failing to practice price discipline.

The benefits of price discipline are so easy to understand that it can be hard to comprehend how we manage to deceive ourselves of the need to engage in market timing. But it clearly is possible to do this. It’s been going on since the first stock market opened for business.

The trick is to keep focused on the present moment and to avoid thinking too much about how stocks have always performed in the long term. One tactic that we employ is to overstate our gains in the heat of bull markets. If you listen to other investors (and we all do -- there is something deep in human nature that causes us to want to turn to our fellow humans to provide reassurance and to help us figure things out), you will hear lots of reports about how stocks are an amazing asset class at just the times when they are most dangerous.

The Buy-and-Hold Advice

The standard Buy-and-Hold advice is that the typical investor should go with an allocation of 60 percent stocks, 30 percent bonds, and 10 percent Treasuries. I advocate that investors increase their stock allocation to 90 percent at times of super-low valuations and decrease it to 30 percent at times of super-high valuations. That suggestion is often met with shock. It cannot possibly be right, can it? Everyone knows that market timing is a bad idea, don’t they?

Something that has often puzzled me is that it is common at times of high stock prices for Buy-and-Holders to go with stock allocation percentages of much more than 60 percent. There’s a fellow who posted at a discussion board that I used to frequent (in the days before I was banned from it) who published a study showing that an 89 percent stock allocation is “optimal.” His allocation recommendation was 30 percentage points above the conventional recommendation just as mine was 30 percentage points below the conventional recommendation. But his recommendation was never met with shock. He was generally viewed as being brave enough to be a bit smarter about stock investing than what the conventional advice called for.

Investors measure success in the short term. A 90 percent stock allocation obviously produces bigger gains than a 30 percent stock allocation during a bull market for the same reason that a 30 percent stock allocation produces bigger gains than a 90 percent stock allocation in the long term for stocks purchased at bull-market prices. It is short-term results that make a bigger impression on the vast majority of investors. It's only researchers who go to the time and trouble to see what works in the long term and the research projects that show the dangers of buying stocks during bull markets don’t tend to go viral at the times when the message they communicate most needs to be heard.

Investors Have Stock Investing Figured Out

Investors who obtain good results brag. It is human nature. Most investors who go with a large stock allocation are worried about doing so at the time they make the choice. So they are relieved when their bet seems to have paid off. And they tell everyone who will listen that they have this stock investing thing figured out. When the losses come, as they inevitably do, they keep it to themselves. Stock gains are reported far more frequently than stock losses.

Which causes us all to form a confused understanding of the realities of stock investing. Most of us go by what we hear from our friends and neighbors and co-workers. They almost always overstate their gains and understate their losses. So we come to believe that stock investing is less dangerous than it in fact is. And our lack of appreciation of the very real risks associated with this asset class causes us to invest in such a way as to earn lower returns than the 6.5 percent real long-term average return suggests should be easily available to us.

That 6.5 percent return is an average. Investors who practice price discipline/market timing beat the average by investing more heavily in stocks at the times when their going-forward return is likely to be higher. It follows that investors who follow Buy-and-Hold strategies obtain long-term returns lower than the average return. We all need to work to tune out what we hear from other investors and from the experts in the field and to focus on what the peer-reviewed research has to teach us about these matters.

Disclosure: None.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Comments

[BubbaJM]

I'm pretty much in agreement with your strategy, and I practice one which is essentially similar. (With a few caveats). I don't personally call it market timing... but, a rose by any other name... (you know the rest), I like to refer to it as a sliding scale for "asset allocation". I based it on a 55 year comparison of different asset allocations from the inception of the S&P500 from it's beginning (in present format) in 1957, up until I started using it fully around 2012, and compared the results with my own sliding scale technique which initially varied from 37% to 87%.... (very close to your 30-90% scale that you suggest). I eventually did some mild "tweaking" which ended up adjusting my scale a bit more narrowly (50%-85%) and added a 10-year bond yield adjustment as well (which I doubt will be of significance in the near future). By the way, my "back testing" gave me a return of 9.2% CAGR using this strategy vs. about a 9.6% CAGR for 100% stocks, but with much less volatility. The reasons for raising my stock allocation at "market highs" which I label as anything above 35% greater than historical median PE's was because I realize during my analysis of market behavior that momentum of above (and below) average returns often tended to dominate returns more than I'd initially realized. For instance by my records, U.S. stocks became fairly valued sometime around 1992, and by 1996 Alan Greenspan had uttered the now famous words of "irrational exuberance". Had I dropped stock allocation to 30% at that time, one would have missed out on 4 years of stellar market returns before the 3 year bear, while holding 50% invested would prevent me from missing out as much, and still leave the bear market blues "manageable" being 50% invested as opposed to 70% - 90%. Similarly, It has helped give me better returns these past 4 years as well, where I consider the US markets well over 35% overvalued. Also, there is always some questions of "normal value" as my assessments of valuations can be (and often are) "imperfect". There are many ways we can value the overall markets, and even a simple measure such as using P/E (which is my personal choice), can be less than simple. We can use forward "operating" or "as reported" earnings, we can use trailing "operating" or "as reported" earnings, we could use "Shiller CAPE 10" ratios ... my own choice is one where I use the previous last "highest" trailing 12 month S&P500 earnings as the denominator and S&P500 present value as the numerator... which prevents me from adjusting my stock allocation downwards if earnings fall faster than stock price which could normally give me a higher PE despite a steep decline in Stock prices, (this prevents me from decreasing my stock allocation at a time when stock prices have fallen sharply.... 2008 being a great example). To complicate matters for myself..lol.. I also figure out my "fair value" for seven different stock market etf's including US large, US large cap value, US small cap value, US REITS, International Large cap, International Small cap, and Emerging markets. My overall allocation to stocks as of late September with S&P500 value of 4,433, was about 55% (with most US etf's at or slightly above 50%, and International etf's closer to 70-80% of what I would normally allocate to those stock positions if all were fairly valued and my fair value stock position was 70% stocks. As I said, I do take 10 year interest rates into account as well, since if we were to have a period again where bonds returned say 7%-12% interest (as they did in the mid 70's - early 80's), it would make sense to lower my risk with less stocks and guaranteed high dividend treasury yields.... but returning to this scenario any time soon, I suspect is highly unlikely. Thank you for your article!

[Sage of Remnant Cove]

Should one listen to an "advisor/columnist" when they say " we do not read comments". Dialogue has a significant place in the history of Western Civilization in ALL intellectual areas ...