It doesn’t mean going all in or out but rather tweaking allocations in response to telltale signals.
Novice investors are constantly told to never – never! - time the market. Just buy and hold stocks, dollar-cost averaging over time. That is good advice. I know some novice investors who have done very well through various economic cycles, buying stocks in both good and bad times – especially the bad times. They have unshakable faith that the market will always come back. If you didn’t have such faith, you wouldn’t be able to invest in this fashion.
I am a professional investor and have timed the market with some success, but not too much because it is very hard to do. But I think novice investors should attempt to time the market once or twice in their investing careers. Sacrilege, I know. I’m not talking about getting totally in or out of the market, but rather about making changes in asset allocation that have the potential to boost returns substantially over time.
Here is how it works. Imagine you have your money in index funds in a traditional 60/40 portfolio. That means 60% in a stock index fund and 40% in a bond index fund. The moment when you are feeling the most ebullient about your portfolio, when it seems like it’s going up most every day and you can’t believe how much you are making, that is the point at which you want to adjust your stock allocation down to 50%.
A friend of mine, Brent Donnelly, president of Spectra Markets, calls this “The Cheer Hedge.” It was from his days working on a foreign-exchange trading desk where he observed that the moment someone made a lot of money and started high-fiving others was the moment at which the position stopped working. If at the moment you were happiest about your investments you reduced risk, you would probably come pretty close to getting out of the market at the highs. When you feel the urge to tell everyone how much you are making is usually when the piano is about to fall on your head. This would have worked exceptionally well during the dot-com bubble and 2021.
Likewise, when you are feeling the worst about your portfolio, when you have abandoned all hope and are considering just liquidating everything to stop the pain, it is probably time to be taking more risk. If you increased your allocation to stocks from 60% to 70%, you would have more exposure when the market inevitably rallied. During the depths of the financial crisis, if people increased risk rather than liquidated, they would have been much better off today.
For example, in a year when stocks return 15% and bonds return 5% in a 60/40 portfolio, the blended return would be 11%. By adjusting the stock portion up to 70% and bonds down to 30%, the return rises to 12%. A small, but noticeable difference. Of course, in the early days of the post-financial crisis market, equity returns were much higher, with the S&P 500 Index gaining 23.5% in 2009. Alas, many missed out on such gains. Surveys by the American Association of Individual Investors showed that most novices only had 41% allocated to stocks at the time.
Financial advisers say it’s impossible to time the market, but it really isn’t. If you can sense big turning points in sentiment, you can make subtle changes to your asset allocation and increase returns over time. But it requires people to go against their intuition, which is hard because when people feel good about their portfolio, they usually want to buy more stocks, and sell when they feel terrible. Humans are hardwired to be terrible investors. So, if you were to do the opposite of what your instincts told you, you would probably be better off. This is not heretical advice. The legendary Warren Buffett has often said to be a successful investor once must be fearful when others are greedy, and greedy when others are fearful.
Some people might interpret this advice as a license to trade actively, but it’s not. I’m talking about extremes in sentiment that happen only about once every 10 or 15 years. One of those came in the first half of last year, when meme stocks were spinning off into space and crypto millionaires were being minted by the thousands. You can monitor magazine covers and the like, but the best way to gauge sentiment is to talk to your neighbors. If they tell you they’re making or losing haystacks of cash in the market, it’s probably time to tweak your portfolio.
This latest downturn in the stock market would not qualify as an extreme in sentiment - at least not yet. We need to get to the point where people believe that the economy is going into a depression and the stock market will go to zero, and it doesn’t feel like there is any sort of mass capitulation happening. Sure, the latest AAII data shows the percentage of bulls hanging right around the lowest levels of the last 30 years, but it’s also notable that Cathie Wood’s flagship ARK Innovation ETF – seen as the pandemic era’s ultimate barometer of investor exuberance - has posted its longest streak of weekly inflows in over a year.
The point isn’t to pick tops or bottoms with precision; the point is to take a little less risk when others are taking more, and vice versa. People try to accomplish this in different ways, such as by studying things like valuations or charts, but the best method is by using sentiment. Novice investors have a voice in their heads that tells them to do the exact wrong thing at the exact wrong time. If you can step back and have some self-awareness of your own emotions, that is what produces outperformance in the long run.
June 28, 2022