“Only liars manage to always be out during bad times and in during good times.”
I recently had a reader ask me a question via e-mail:
I’m writing regarding the research by Dr. Wade Pfau that suggests that retirees are significantly better off holding only 20% in equities during the first five years of retirement.
I also found the article you worte in support Dr. Pfau’s conclusions for early retirees very interesting.
While the approach seems prudent, the question is whether this is a form of market timing? Is the difference that the allocation goes back to normal after the first five years?
Note: As per Wade Pfau’s comment below, he doesn’t actually recommend that retirees hold 20% in equities in their first five years in retirement. He recommends a rising equity glidepath starting in retirement. See his article on OneFPA.org for more. I did do research on a flat equity assumption for early retirees in “Asset Allocation for Early Retirees.” If somehow my research got confused with Wade’s, that’s a heck of an honor!
In order to answer this question, we need to first define market timing and then explain why this reader is concerned that we might be trying to attempt market timing. After that, we’ll tackle whether this (or any other asset allocation scheme) is actually market timing.
What is Market Timing?
I prefer to use a pretty simple definition of market timing.
To me, market timing is when an investor tries to guess, beforehand, whether or not the stock market or an individual stock is going to go up or down, and makes an investment based on that guess.
Think the market is going to go up tomorrow? Put in your buy order right at market open. Seen a triple top double shoulder Mick Jagger formation in your favorite penny stock? Short sell or buy a put!
Does Market Timing Work?
In a word, no.
Oh, and no.
Market timing is alluring because we like to think that we’re in control of our futures. We like to believe that we know more than we actually do. We think that because we read forums, watch Jim Cramer on CNBC, or have a special direct line to the Oracle in Delphi (or Omaha), we can tell what’s going to happen to the stock market tomorrow.
Simply put, we cannot. Study after study, time after time, stock market investors who try to time the markets wind up with less money in their pockets (even when they say “this time, it’s different!“).
Don’t do drugs. Don’t time the market. Just say no.
But Isn’t Asset Allocation Just a Fancy Way of Timing the Market?
Herein lies the crux of my reader’s question – by suggesting any sort of asset allocation, whether it’s 110 – your age or the a rising glide path in retirement, aren’t we simply saying that you should try to time the market?
The answer is no.
Market timers try to predict what is going to happen to the market tomorrow or at some point in the future.
Investing with asset allocation doesn’t try to predict what’s going to happen tomorrow. It uses historical data to attempt to minimize down side risk while maximizing either the up side of an investment (investing at 110 – your age when you’re young) or keeping pace with inflation (rising glide path in retirement).
Let’s look more specifically at the thinking behind the Kitces/Pfau model that the reader referred to.
What is the goal of that asset allocation model?
Is it to get filthy rich and swim around in gold coins like Scrooge McDuck?
The goal of that investment model is to avoid a significant hit to your portfolio in the time when your portfolio is most vulnerable to large swings – the five years before retirement through the first five years after retirement.
A large hit right before you retire probably means that you’ll either have to delay retirement or significantly reduce the amount that you can safely spend in retirement (see “Revisiting SAFEMAX” for more). A large hit right after you retire means that you’ll either have to cut back your already extant retirement lifestyle or go back to work (see “Six Areas Where I Disagree with Dave Ramsey’s Investing and Retirement Withdrawal Advice” for more on sequence of returns risk). Both are pretty psychologically painful scenarios.
But, it’s not market timing because you’re making a decision about a fixed point in time – when your birthday or when your retirement age is – rather than trying to react to what you think about what is going to happen to the markets in the future.
Instead, you’re investing in a way that minimizes volatility (in the Kitces/Pfau model) and reduces the risk that your portfolio is going to get kneecapped right when it can least afford to take the hit.
The same holds true for asset allocation. I recommend that you rebalance your portfolio once a year, and make it the same day every year, either the first trading day of the year or your birthday. That way, you’re not tempted to see the market, think “oh, wait, the stock market went up 200 points yesterday…I’ll wait a day and see if it drops before changing my asset allocation.” You just do what the plan tells you to do and forget about it until next year.
This also holds for value cost averaging. Pick a day each month and execute on your plan on that day. Don’t look at the market and try to pull out your cataract filled crystal ball. It will only cause you to lose money because you’ll invariably invest at the wrong time. It’s better to attempt to buy low and sell high probabilistically than by your gut or feelings.
So, really, asset allocation strategies, whether it’s some number minus your age or using a declining, plateaued, and then rising glide path, as well as value cost averaging are specifically designed not to be market timing strategies. They are meant to be programmatic, process-driven strategies that attempt to take advantage of long term market trends rather than the short term trends that market timers perceive that they observe.
To misquote Gandalf from The Lord of the Rings: