Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.
Buy low, sell high. It’s deceptively simple advice, but few investors seem to succeed at doing so. Long-running research shows that the average equity investor underperforms the market by 400 to 600 bps per year– more than half of the overall return of the index in many cases! Why is this so? To put it simply – fear and greed. Investors tend to pile in money when times are good, only to panic and sell when times are bad. They also have a pathological attraction to failing companies and a bizarre avoidance of boring, profitable companies. These studies get tossed around by the index fund industry as proof that investors can’t time the market, but there’s actually some deeper meaning worth considering.
Game Theory Optimal Vs. Exploitative Investing
Like it or not, the stock market is the world’s biggest and richest game. We risk our money against millions of other anonymous participants via our phones and computers each day. The market is incredibly complex, and investors can play the game as conservatively or aggressively as they so choose, and many choose not to play at all. The aristocracy historically just sunk their money into property and rented it out – that’s not as much of a game, it’s more of a straightforward business. And here in Texas, many of the multimillionaires I know have zero exposure to the stock market -instead putting their money in real estate and private businesses.
The stock market has more than a few parallels with other games that are played for money, especially poker. And one of the key questions of poker is whether you should play in an unexploitable way that guarantees a decent profit over the long run, or whether you should actively take advantage of the mistakes of your opponents. Playing not to be exploited is known as “game theory optimal,” or “GTO”, while playing to capitalize on the mistakes of others is called “exploitative.” Done right, exploitative gameplay is much, much more profitable.
Here, the “game theory optimal” solution to the stock market is to buy and hold broad market index funds. If you buy and hold the total market index (VTI), you’re unexploitable. You will pay an annual fee of 0.03% per year but otherwise will not lose to the index. Since its inception in 2001, VTI has returned about 7.9% annually with dividends reinvested. Notably, this is a bit better than the S&P 500 (SPY), which tracks a narrower index.
But earning a bit less than 8% annually probably will not make you filthy rich unless you have a lot of money to invest. You gain ground against the vast majority of investors, but it’s not going to get you to a boat on the French Riviera. That’s because by becoming unexploitable in your investment strategy, you lose the ability to capitalize on the fear and greed of the masses. To make truly big money, you need to adopt an exploitative strategy. The game of making alpha in the stock market is zero-sum. If millions of individual investors are underperforming the market, that money doesn’t just disappear. Some is absorbed by the finance industry as fees, but most of it is simply lost to smarter (or more patient) investors.
So if most investors are losing, how do we exploit that? There are basically two ways:
1. The first is to exploit the cross-section of assets. This is a fancy way of saying stock picking. There’s tons of academic research on this, but generally:
- You want to buy profitable, quality companies and sell junk and hype. This is known as the quality-minus-junk anomaly. High-quality companies outperform junky ones by about 500-600 bps per year.
- You want to own more small and unknown companies and fewer of the popular mega caps. This is a smaller bias but an important one because it’s easy to tilt towards.
2. The second and potentially more interesting way is to exploit the time series of assets. This is a fancy way of saying market timing. Cross-sectional anomalies get much more attention, but the potential gain from timing the market matches or exceeds what can be done from stock picking.
- Investors tend to hold onto their worst stocks for the longest, and are quickest to sell their winners. This is a huge bias known as the disposition effect. The market timing implication here is that stocks tend to have momentum. Good stocks stay cheap because people sell to cash them in, while bad stocks of failing companies tend to hang around as people pump more and more money into them to get back to even. Winners keep winning over years and decades, while losers keep losing. This is likely the single biggest contributor to the gap between index returns and average investor returns.
- Investors have a tendency to herd. People get very excited and load the boat during bull markets, and during bear markets, they panic and sell. Small retail traders tend to do this more than any other investing group. If you go against the herd, you can profit.
I think you can make arguments for either being GTO here with index funds or profiting from irrational trading behavior to the best of your ability. Bulls and bears can both make money, but whatever you do, don’t be a pig.
Should You Ever Try To Time The Market?
I’d say yes – when stocks get sufficiently mispriced.
If you google “market timing,” you’ll get a long list of articles written by mutual fund companies telling you not to do it! But study after study will show you that investors pump money into stocks when prices are high, only to pull them out when prices are low. In the last 25 years, stocks have fallen by around 50% twice from 2000-2002 and 2008, nearly doubled from 2002 to 2007, quadrupled from 2009 to 2019, and have made huge moves in both directions since the pandemic. As I said earlier, VTI has made you about 7.9% annually since 2001. The average investor probably made closer to 4%, while savvy market timers easily made 12% annually or more. The 2008 stock market collapse took most people by surprise, but the dot-com bubble had plenty of obvious red flags, as did the 2000s housing bubble and the 2020-2021 everything bubble.
Cutting risk into falling markets holds up fairly well to backtests as well, so long as you’re willing to put it back when things calm down. I think everybody has stories of someone who sold out everything in 2008 or March 2020 and never got back in. Panic selling is a losing strategy, just as panic buying in a bull market is. The difference is that effective market timing is generally a proactive risk management exercise rather than a panic-driven emotional system.
Instead of just telling you to buy low and sell high, I can share some quantitative tools that tell you how much to invest. I’ve shared these before, but most recently in my market timing article last year.
Basically, the optimal amount of cash to hold in your portfolio can be boiled down to an equation. This is a ballpark figure, but it’s very useful nonetheless. I didn’t invent this, but I used it in school to build trading strategies for leveraged ETFs.
Equity allocation = Expected return -Cash rate / Standard deviation ^2
If we just plug in the long-run return of VTI going back to inception, we get an expected return of 7.9%. The Fed is likely to hike cash rates to 5.25% this month, and the VIX is about 20. Therefore, we get an excess return of 2.6% and a standard deviation squared of 4. 2.6/4= 65%, which is the recommended amount to hold in equities by the model. Therefore, the model is telling you to hold 35% cash and 65% equities. The model changes in real time. When we ran the model last year, it recommended about 12% exposure to cash. The idea here is that stocks aren’t offering a whole lot of long-run return in excess of cash, while risk is increasing. That’s generally a warning sign that the market is due for a drop. Given that cash rates are headed higher and earnings estimates are pretty shaky for stocks, this model is actually probably fairly conservative in how much cash it’s holding. And note that when I write cash here, I mean money market funds such as those offered by Vanguard, or simply Treasury bills. They have a Federal Money Market Fund (VMFXX) as well as a Municipal Money Market Fund (VMSXX). As for which of these is better, it’s generally VMSXX if you’re in the top tax bracket, but I made a spreadsheet with breakevens for those interested. For now, it looks like the normal money market funds are better for most investors.
Muni vs. taxable money market sheet link- Munis_Vs._Taxable_Money_Market.xlsx.
Should You Time The Market Now?
There’s a fine line between asset allocation and market timing. Many investors are comfortable with decisions that are framed as asset allocation while uncomfortable with decisions that are framed as market timing.
What we have going on now is that the Fed is trying to slow down the economy, and has rapidly raised cash rates as a result. Responding to this incentive is partly a market timing decision, but it’s partly an asset allocation decision also. If you can earn about the same return in cash that you can by taking tons of risk, the Fed is hoping that you’ll take them up on the former. Savvy market observers are thinking that cash rates may go to 6% and stay there for 12+ months to finally bring inflation back to 2% in the US.
Meanwhile, sell-side analysts have 2024 earnings estimates that are borderline delusional, showing not only no recession in the US but a massive earnings boom on top of it. When you dig into how much of the US economy has been driven up by tax cuts and lower interest rates over the last 20 years, you can see that this is extremely improbable. It’s not that the US is a bad country or that the global economy is totally failing – it’s that the prices of equities and housing in large part still do not reflect economic and political reality. Rather, they reflect households who went nuts with borrowing in a cycle that has played out over centuries in more or less similar ways. To this point, I think you should absolutely respond to the Fed’s incentive here by allocating at least some of your money to cash. Of course, you open yourself up to being wrong if bulls are exploiting you by buying your stocks too cheap at roughly 18-20x earnings on the S&P 500, but you exploit them if this time isn’t different than the past hundreds of years. That’s a bet I think you should take.