Wednesday, November 13, 2013

Why it’s so dangerous to time the markets

Investor John Hussman is a smart guy. He seems nice. This is nothing personal.

But Hussman is bearish on stocks. He has been for a while. With the S&P 500 up more than 20% this year, he sounds about as pessimistic as he ever has, leading to a big front-page story in Business Insider last weekend. Hussman recently wrote:

I continue to believe that it is plausible to expect the S&P 500 to lose 40-55% of its value over the completion of the present cycle, and suspect that whatever further gains the market enjoys from this point will be surrendered in the first few complacent weeks following the market's peak.

I won't argue with this. Stocks have done well. You could call them pricey. There will be more crashes.

But Hussman has been so sure of his outlook that he's had a substantial "short" position in his flagship fund for years. As the market surged, his returns have been decimated.

The irony is that in the process of preparing for the possibility of a 40% crash, Hussman's fund has almost suffered an actual 40% crash. This is the financial equivalent of burning your house down to avoid any chance of it being damaged in a wildfire.

The gap between S&P 500 returns and Hussman's returns is now so deep that even if his crash predictions come true, it's not at all clear that he'd win. Hussman needs to beat the S&P by more than 100 percentage points just to break even against the index over the last decade. That is a massive hurdle. I don't know if it's ever been done before. (To be fair, Hussman's returns since data collection began in November, 2000 have trailed the S&P 500 by a smaller amount, eight percentage points, according to S&P Capital IQ).

What do we learn from this? Two things.

One, there are two types of risk. The first is what author William Bernstein calls "shallow risk," or a temporary fall in an asset's market price. Stocks fall, maybe by a lot, but recover in a few years and life goes on. The other is "deep risk," or a perm! anent loss that's nearly impossible to recover from. I think there's a growing chance people like Hussman tried to avoid shallow risk, and in the process are now facing deep risk. Because of inflation, real growth and retained earnings, the market has a clear upward bias over the long run, and so missing rallies can be more harmful than getting caught in downturns. Put another way, avoiding a 40% crash leaves you worse off if it also causes you to miss a 170% rally.

Two, there's an old saying in finance: "Do you want to be right, or do you want to make money?" If you're in the punditry business all that matters is "being right." Successfully managing money is different. Rather than attempting to avoid risk, I've come to believe it's far more efficient to accept it, taking the market ups and downs as they come. This means you forgo the glory of getting big calls right, but it increase your chances of making money in the long run.

I wish everyone the best, including Hussman and his investors. Maybe he'll prevail in the end. But remember what President Eisenhower said: "Pessimism never won any battle."

The Motley Fool is a USA TODAY content partner offering financial news, analysis and commentary designed to help people take control of their financial lives. Its content is produced independently of USA TODAY.



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