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A Noble Lie

Why it's OK to sin a little and "market-time"--provided you do it in a contrarian fashion, says Morningstar's Sam Lee.

Samuel Lee, 12/10/2013

A common nugget of wisdom passed down from on high to the masses is to "buy and hold," which really means several things: Set fixed allocations to stocks, bonds, and cash; dollar-cost average into the portfolio with periodic purchases; and, above all, stay the course. I tell investors to do these things all the time, too, because on the whole it's good advice.

It's also a noble lie, an untruth told to investors to keep them from hurting themselves.

You can detect a contradiction when juxtaposing the advice with the well-established fact that, in aggregate, individual investors are perverse market-timers, selling low and buying high. If investors manage the feat of reverse market-timing, wouldn't doing the opposite of what they do lead to successful market-timing?

Either the market is predictable or individual investors are not reverse market-timers. Something has to give.

Which is it?

Here's a hint: Eugene Fama and Robert Shiller shared this year's Nobel Prize in Economics in part for showing that returns are predictable over long horizons. They found when valuations are low, expected returns are high, and vice versa.

Yes, Fama, the father of the efficient-market hypothesis, believes the market can be sorta-kinda timed. In an interview with The New York Times, he said, "If I were to characterize what differentiates me from Shiller or [Richard] Thaler, it's basically we agree on the facts--there is variation in expected returns, which leads to some predictability in returns. Where we disagree is whether it's rational or irrational." [1]

This wasn't a recent change of heart. Fama and many other researchers discovered return predictability all the way back in the 1980s. Somehow, during the past 30 years, the academic research was translated into the dictum that you should never, ever change your asset allocation, except in response to changing risk tolerance.

Samuel Lee is an ETF Analyst with Morningstar.
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