How Does Value Investing Differ from Market-Timing?

Value investors buy securities when they think those securities are cheap. Doesn't that make them market-timers?

Not necessarily. In fact, there is a vast gulf between being a value investor and being a market-timer. In this piece we'll discuss what the difference is and why you should be the former.

The Business-Owner Approach to Investing
The classic form of value investing is to think like a business owner and aim to purchase ownership units in businesses for less than those businesses are worth. Those who take the business-owner approach to investing tend to understand that securities can get even cheaper over a one-, two-, or three-year period, but that the market should realize the correct value of businesses over the longer run. Maintaining an ownership approach to investing and understanding that you originally purchased the assets at cheap prices can help you stay the course when the market keeps making the prices cheaper in the shorter run.

The same is true for selling. As told in Charles Ellis' book Capital, when asked how he supposedly timed the market so well by selling stocks in early 1929, the founder of Capital Research (parent of the American Funds) Jonathan Bell Lovelace remarked that he realized that stocks were selling for more than what any reasonable buyer would pay for the entire underlying businesses. According to Lovelace, banks, in particular, were selling for more than the deposits on the balance sheet--and the deposits are what the bank owed, not owned. This is how Lovelace found the courage to sell when everyone else was buying. His shift out of stocks must have seemed silly in the short run as prices continued to skyrocket through most of 1929, but allowed him to preserve his fortune in the long run. This business-owner approach to investing is exactly the one advocated by Benjamin Graham, who is widely considered to be the father of value investing, and his most famous student Warren Buffett.

There is an element of timing in waiting for the market to give you a business for less than you think it's worth or selling into a market that's willing to give you more than it's worth. However, the business-owner approach to investing helps you maintain your patience when the market sends a stock that you think is cheap even lower, and it helps you remain content when something you've just sold keeps rising. In fact, if you take the business-owner approach to investing and a stock that you've just bought goes lower, you'll naturally be inclined to add to it, not sell it.

Finally, valuing a business means just that: looking at and choosing individual businesses for investment rather than the entire market. It's easier to have conviction about your assessment of individual businesses than it is about the entire market or an asset class.

The Market-Timing Approach to Trading
In contrast to the business-owner approach, market-timers don't care about the underlying business of a stock they're considering for purchase. They tend to view stocks as squiggly lines on a graph, as Buffett says, instead of representing ownership units of actual businesses with sales, expenses, assets, liabilities, and (hopefully) profits. Market-timers are trying to gauge short-term supply-and-demand pressure on securities or, if they're buying now, after the market's decline, trying to catch a rebound. They are generally more interested in the psychology of market participants and what kind of supply-demand pressure that will create in the short-term than on the value of underlying businesses.

To use Graham's parlance, market-timers tend to be "instructed" by the market regarding what the proper price is for a stock, rather than "served" by the market by maintaining an independent estimate of a business's value and waiting for the market to sell it to them for less than that estimate. So market-timers may buy when things look grim, but it's harder for them to hold on to their purchases if supply-and-demand pressure doesn't send stocks higher in the short-run or quickly after they've made their purchase. Without an understanding of underlying business value guiding their actions, market-timers indeed don't have a good reason to hold on to stocks in a market going against them. They are, in fact, behaving logically or consistently with their theory when they sell quickly to avert further losses.

This emphasis on the market instead of underlying business value can make it difficult to stay the course (or even buy more) when market forces don't immediately pan out as planned or hoped for. If you're making your bet on investor psychology rather than underlying business fundamentals, and psychology doesn't change quickly, then you're in trouble.

The Practical Lesson
Stocks look a lot cheaper now than they have in recent years, and it's often a good idea to buy stocks when the market has plummeted as it has in recent months. As Warren Buffett says, "Be greedy when others are fearful and fearful when others are greedy"--and there sure seems to be a lot of fear out there right now. However, there are a few things to consider before diving in.

First, make sure you're buying because you think underlying businesses are cheap, and not because you want to time a short-term rebound. The business approach will help you stay the course if stock prices get cheaper still. Buffett remarked in his recent New York Times editorial that he was moving into stocks because he thought they'd be great long-term investments at these prices, not because he thought the market was necessarily going to rebound soon. Buffett is also selecting individual securities that he thinks are particularly cheap.

Second, stay within your asset-allocation limits. Don't put all your money into stocks unless you're in your early 20s--if even then. Use something like Vanguard founder Jack Bogle's rule: 100 minus your age should approximate the correct percentage of stock exposure. Some people prefer 110, but the important thing is to choose something and stick with it. Whatever your age, now is a great time to rebalance your portfolio because stock market declines have undoubtedly taken your stock exposure lower. But don't exceed your optimal exposure, as defined by Bogle's rule or some reasonable substitute.

Third, stick with funds with experienced managers and good long-term track records. Our  Fund Analyst Picks list is filled with them.