The bear market turned buy-and-hold investors into hem-and-haw investors. People who bailed out are agonizing over whether the time is right to jump back in. In other words, they're trying to time the market -- just what they used to vow they would never do.
Does it make sense to time the market, or are you better off adhering to your target mix of assets -- say, 60% stocks, 30% bonds, and 10% cash? New research has brought fresh economic insight to the issue. The bottom line: Ordinary investors probably can come out a little bit ahead by timing the market. But it's easy to get your timing wrong, so don't stray far from your target.
One of the most respected academic proponents of cautious market timing is John Y. Campbell, an economist at Harvard University and a managing partner of Arrowstreet Capital LP in Cambridge, Mass., which manages $4 billion of international stocks for pension funds and endowments.
To make his case for market timing, Campbell divides people into two camps: those who believe that stock prices move in a random walk, and those who believe that they revert to the mean. If the random walkers are right, then stocks aren't a safe long-term investment, because the range of possible outcomes rapidly widens over time. Let's say that, in any given year, stocks can go up or down randomly by as much as 25%. After one year, your $100 could turn into a maximum of $125 or a minimum of $75. But if you left the money for 20 years, it could grow to as much as $8,670 or shrink to as little as 32 cents.
That's why most people who advocate stocks as a long-term investment reject the random walk. Instead, they believe in mean reversion, where the range of likely outcomes widens much more slowly. Mean reversion says that if price-earnings ratios have gotten way above average (as in the 1990s), their next move is likely to be down (as in the 2000s). Think of it this way: An imaginary mean-reverting coin that came up tails nine times in a row would probably come up heads on the 10th throw, whereas an ordinary, random-walk coin has a 50% chance of coming up tails yet again.
MIND-BOGGLING. Assuming that mean reversion holds, you should be able to profit by buying when stocks are low and selling when they're high. Yet pure buy-and-holders don't do that. Campbell argues that their disbelief in the potential for market timing is "logically inconsistent" with their belief that mean reversion makes stocks safe for the long run.
The theoretical potential of market timing is mind-boggling. Economist Andrew W. Lo of Massachusetts Institute of Technology calculates that someone who invested all his money in either the Standard & Poor's 500-stock index or Treasury bills, somehow correctly picking each month the one that would go up the most, would have turned $1,000 in 1926 into $14 trillion in 2002.
That, of course, would have required faultless foresight. Campbell advocates something more modest: "aggressive rebalancing." For instance, if your target is 60% stocks and a bull market raises stocks' share to 80%, consider selling stocks to bring the allocation down to, say, 50%. Just don't overdo it. "Strategic market timing should be done cautiously," says Campbell, "because people are likely to mess it up."
Campbell may seem diffident, but he's a bull on market timing compared with Wharton School economist Jeremy J. Siegel, author of Stocks for the Long Run. True, Siegel wrote a prescient op-ed piece, "Big-Cap Tech Stocks Are a Sucker Bet" that ran in The Wall Street Journal on Mar. 14, 2000, virtually the bull market's peak. Even though he nailed that one, Siegel says, "once you open the door to market timing, unless you're extraordinarily disciplined, you often get it exactly wrong." Burton G. Malkiel, author of A Random Walk Down Wall Street, points out that mutual funds tend to sit on the largest amount of cash when stock markets are at their bottoms and the least when they're at their tops -- the opposite of what they should do.
People who do believe in active management have long regarded market timing as a better choice than stock-picking. That goes back to a 1986 paper by a group led by Gary P. Brinson, now of Chicago's GP Brinson Investments. Remember that market timing is another name for asset-allocation shifts, because the way you time markets is by periodically changing your mix of assets between stocks, bonds, and cash. The Brinson team famously concluded that the balance of asset classes -- rather than the choice of stocks -- accounted for 94% of the variation in mutual funds' total returns over time.
A new study shows that the choice of asset allocation -- i.e., market timing -- isn't as potent as the Brinson paper implied. Stock-picking is a more powerful method of active management, says new research by Mark Kritzman, managing partner of Windham Capital Management Boston LLC, and Sebastien Page, a senior associate at State Street Associates (STT ) But Kritzman and Page don't tell investors to ditch their index funds and instead pick stocks. While stock-picking can produce higher highs than asset allocation, it can also produce lower lows. So if you aren't highly skilled, Kritzman says, you'll probably do more harm by toying with stock selection than you would by tinkering with your asset allocation.
The upshot: Active investing through cautious reallocation of assets might add juice to your returns. But it's no substitute for the basics, like setting a sensible target asset mix and keeping investing costs low. Both Kritzman and Campbell put a lot of their own money into plain-vanilla index funds.
Memo to investors who bailed out of stocks: Get back in. Not because this is an ideal time to invest -- who can be sure of that? -- but because you're probably under your target allocation of stocks. And for most of us, sticking to the plan is the biggest factor in investing success.
By Peter Coy