Kenneth French on Market Timing, Investor Confidence, and Portfolio Building

Most people who try to time the market, increasing their exposure when they think the market's going to do well, reducing their exposure when they think the market's going to do poorly, are just fooling themselves. They don't actually have the ability to forecast the market. People are often confused about what it takes to succeed as a market timer. Suppose I'm trying to make money by betting on football. If I study everything I can find about this sport, the players, the coaches, weather forecasts, even the refs, I can probably identify a few games each week where I'm pretty sure about which team is more likely to win. But that's not enough for me to make money. I don't make money by just betting on some favorites. I make money by beating the spread. The spread essentially levels the field, taking away the favorite's advantage by giving the underdog extra points. Bookies set the spread so there's an equal amount bet on each team. To make money, I have to know when the spread is wrong. Betting on the underdog when the market has overestimated the favorite's advantage, and betting on the favorite when the market has underestimated its advantage. This is much harder for me to do than just identifying the favorite. Timing the market works the same way. It's not good enough to correctly forecast that the economy will expand, or that we're going into a recession. Just like the bookie's spread, stock prices incorporate the aggregate forecast of all other investors. To win, I have to figure out what that forecast is, and whether the forecast is too high or too low. It's me against the classic wisdom of crowds. Just like when I'm betting on football, I don't win just by identifying the favorite, predicting whether the economy will expand or contract. I have to figure out whether the forecast in stock prices is too optimistic or too pessimistic. And to make the problem even harder, no one tells me what forecast the market has priced in. When I'm betting, I know exactly the spread I'm betting against. In the stock market, I'm guessing what the spread is. Like the bookie's cut in the betting market, market timers have to cover at least three costs before they make money. First, despite the fierce competition among brokerage firms, we know it's not actually free to trade in and out of the market. Second, even unsuccessful market timing is likely to increase expected taxes. Third, market timing can consume lots of time and energy. And there's another problem. Market timers who don't really have skill are just screwing up their portfolio. Suppose your ideal portfolio is 60% stocks, 40% bonds. When you try to time the market without any real insights, you're just moving away from that portfolio. In other words, most investors shouldn't try to time the market. When they do, they're simply spending resources to move away from a better portfolio.

Wie ich mein Portfolio zwischen Aktien und Anleihen aufteile, basiert auf meinen Reuegef�hlen. Ich suche eine Balance zwischen der Reue beifallenden Kursen, weil ich so viele Aktien habe, und der Reue bei steigenden Kursen, dass ich nicht mehr Aktien habe. Ich glaube an zwei Marktmechanismen, die meine Allokation beeinflussen. Ich bin fast sicher, dass es eine betr�chtliche Aktienpr�mie gibt, und ich bin mir absolut sicher, dass ich kein Markt-Timing beherrsche. Beide �berzeugungen lassen mich meinen Aktienanteil erh�hen, denn dadurch bin ich weniger zerknirscht, wenn die Kurse fallen. Auf diese Weise minimiere ich Reuegef�hle bei der Verwaltung meines Portfolios. Ich habe dieses Konzept nicht aus Finanzb�chern, aber es funktioniert f�r mich. Wenn ich schon beichte, kann ich noch etwas hinterherschieben. Ich kenne meine Aufteilung zwischen Aktien und Anleihen in der Regel nicht sehr genau. Denn auch durch Nichtwissen kann ich meine Reuegef�hle reduzieren. Und weil ich meine genaue Aufteilung nicht kenne, wei� ich auch nicht, ob ich mich besonders �rgern muss, wenn die Kurse deutlich steigen oder fallen. Ich versuche, Reuegef�hle grunds�tzlich zu reduzieren, indem ich meine Entscheidungen nicht nachtr�glich infrage stelle. Orientiert man sich an Entscheidungen und nicht an Ergebnissen, n�tzt es nicht viel, die optimale Asset Allokation bestimmen zu wollen. Erstens l�sst sich die optimale Aufteilung gar nicht ermitteln. Zweitens schafft die Aktienpr�mie einen Konflikt zwischen Risiko und erwarteter Rendite, der den Unterschied zu einer theoretischen Optimalallokation �berschattet. Wenn ich zu viele Aktien habe, trage ich auch mehr als das optimale Risiko. Doch die Aktienpr�mie kompensiert dieses Risiko durch eine h�here erwartete Rendite. Wenn ich zu wenige Aktie habe, sinkt meine erwartete Rendite, aber auch mein Risiko. Und drittens verstehe ich jetzt, dass der Zufall das Ergebnis bestimmt � egal, was ich tue. Je l�nger ich lebe, desto mehr sch�tze ich die Bedeutung des Zufalls, nicht nur auf den Finanzm�rkten, sondern im Leben allgemein. So wird es immer einfacher f�r mich, mich auf die Qualit�t meiner Entscheidungen zu konzentrieren, nicht auf das Ergebnis. Ich nutze immer noch meine alten Tricks zur Minimierung von Reuegef�hlen, um mein Portfolio zu verwalten; aber ich bin mir nicht sicher, ob ich sie noch brauche.

Most people should use a top-down approach when they build their investment portfolio. The top-down approach starts with a simple observation. The combination of all investors portfolios is the aggregate market portfolio of all stocks, bonds, and other assets people hold for investment purposes. This means the average dollar invested holds the market portfolio. And if we weighed investors by the size of their portfolios, the average investor also holds the market portfolio. The global valuate market portfolio is really well diversified doesn't have much turnover and is relatively low cost. All that's great, but the global market portfolio is probably not ideal for you unless your situation is essentially the same as the valuate average of all investors, in general your portfolio should differ from the market because you're different from the typical investor. For example, if you're more risk averse than average, you should have less than the market's weight in stocks and more in bonds. Besides risk aversion, how might you differ from the average investor? One difference is the country you live in. All countries are in the valuate average of investors residences, but most of us live in only one country, almost all U.S. citizens for example, live in the U.S. get paid in dollars and consume things that are priced in dollars. For this and probably lots of other reasons. Americans tend to overweigh U.S. stocks and bonds and underweigh foreign assets, a large payment that's due soon can be a big difference between you and the average investor. A couple about to close soon on their first home should think about moving the money they'll need from risky assets to short term treasuries or cash, so they're sure it's available. Your labor income might also distinguish you from the average investor. An entrepreneur who built and still owns the lion's share of the large growth company may diversify by tilting her portfolio towards small and value stocks. You might decide to tilt towards small, value, momentum or any of the other premiums researchers have identified because given your tastes and preferences, the higher expected returns these stocks offer more than compensate you for whatever downside they bring with them, or maybe the difference between your preferences and the average investors pushes you in the other direction toward lower expected returns and presumably less risk. Your personal tax situation will almost certainly be different from the average investors. Capital gains taxes for example, might keep you from selling highly appreciated assets that dominate your portfolio, unless you use some complicated and probably expensive tax management strategy. The best you can do is move back toward the market portfolio by filling in around your appreciated positions. Finally, you may think you're better at identifying over an undervalued assets, then the valuate average of all investors, if you are, that's great. Lots of research suggests however that after costs, few of us have enough of an advantage over the combined wisdom of all other investors to systematically make a profit. Many of us ignore that bad news. In fact, I've taught enough MBA students to know that confident optimism often overwhelms discouraging evidence, regardless of how compelling it is. In short when I talk to individual investors about their ideal portfolio, I focus on the important ways they differ from the valuate average of all investors.