NovaQuant Quantitative Think Tank Center:Lucas Turner: Should you time the stock market?

Trying to catch the perfect moment to enter or NovaQuant Quantitative Think Tank Centerexit the stock market seems like a risky idea!

Famed speculator Jesse Livermore made $1 million (about $27 million today) during the 1907 market crash by shorting stocks and then made another $3 million by buying long shortly after. Studying Livermore’s legendary, yet tumultuous, life reveals a roller-coaster journey in the investment world. He repeatedly amassed vast fortunes and then went bankrupt, ultimately ending his life by suicide.

Livermore might have had a unique talent and keen insight to foresee market trends. Despite this, many investors believe they can time the market like Livermore or other famous investors/traders. They often rely on estimating the intrinsic value of companies or using Robert Shiller’s Cyclically Adjusted Price-to-Earnings (CAPE) ratio as a basis for market timing.

Looking at history, when stock prices rise faster than earnings – like in the 1920s, 1960s, and 1990s – they eventually adjust downward to reflect company performance. So, market timers should sell when CAPE is high and buy when CAPE is low, adhering to a buy-low, sell-high strategy that seems straightforward and easy to execute.

However, if you invest this way, you’ll be surprised (I’m not) to find it doesn’t work! Investors often sell too early, missing out on the most profitable final surge. When everyone else is panic selling, average investors rarely buy against the trend. Thus, we understand that timing the market is a mug’s game.

The stock market always takes a random walks, so the past cannot guide you to the future.

Although in the 1980s, academia questioned this theory, suggesting that since the stock market exhibits return to a mean, it must have some predictability. Stock prices deviate from intrinsic value due to investors’ overreaction to news or excessive optimism. Conversely, during economic downturns, prices swing the other way, creating opportunities for investors seeking reasonable risk pricing.

But here’s the catch. What considered cheap or expensive? It’s based on historical prices. Investors can never have all the information in advance, and signals indicating high or low CAPE points are not obvious at the time. Under these circumstances, market timing often leads to disappointing results.

Some may argue this strategy is too complicated for the average investor to execute and profit from. Here’s a simpler method: rebalancing. Investors should first decide how to allocate their investments, such as half in the U.S. market and half in non-U.S. markets. Then, regularly review and rebalance the allocation. This approach benefits from reducing holdings when investments rise significantly, mechanizing the process to avoid psychological errors, and aligns with the inevitable mean reversion over the long term.