Swedroe: Better To Face Correction

October 18, 2017

Cost Of Waiting

Elm Partners provided some valuable insight into the question of whether investors should wait to buy equities because they believe valuations are too high. Looking back at 115 years of data, Elm asked: “During times when the market has been ‘expensive,’ what has been the average cost or benefit of waiting for a correction of 10% from the starting price level, rather than investing right away?” It defined “expensive” as the occasions when the stock market had a CAPE ratio more than one standard deviation above its historical average.

Elm noted that while the CAPE ratio for the U.S. market is currently hovering around two standard deviations above average, there aren’t enough equivalent periods in the historical record to construct a statistically significant data analysis.

It then focused on a comparison over a three-year period, a length of time beyond which they felt an investor was unlikely to wait for the hoped-for correction. Following are its key findings:

  • From a given “expensive” starting point, there was a 56% probability that the market had a 10% correction within three years, waiting for which would result in about a 10% return benefit versus having invested right away.
  • In the 44% of cases where the correction doesn’t happen, there’s an average opportunity cost of about 30%—much greater than the average benefit.
  • Putting these together, the mean expected cost of choosing to wait for a correction was about 8% versus investing right away.

The takeaway is this: Even if you believe the probability of a correction is high, it’s far from certain. And when the correction doesn’t happen, the expected opportunity cost of having waited is much greater than the expected benefit.

Elm offered the following explanations for why it thought the perception exists among investors that waiting for a correction is a good strategy: “First, while a correction occurring is indeed more likely than not, investors may confuse the chance of a correction from peak-to-trough with the lower chance of a correction from a fixed price level. For example, the historical probability of a 10% correction happening any time during a 3-year window is 88%, significantly higher than the 56% occurrence of that correction from the market level at the start of the period. Second, the cost of waiting and not achieving the correction is a ‘hidden’ opportunity cost, and we humans have a well-documented bias to underweight opportunity costs relative to realized costs. Finally, investors may believe they can wait indefinitely for the correction to happen, but in practice few investors have that sort of staying power.”

Elm repeated its analysis with correction ranges from 1% to 10%, time horizons of one year and five years, and an alternate definition for what makes the market look “expensive” (specifically, waiting for a correction from times when the market was at an all-time high at the start of the period).

The firm found that “across all scenarios there has been a material cost for waiting. The longer the horizon that you’d have been willing to wait for the correction to occur … the higher the average cost.”

Summary

Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”

And we certainly live in uncertain times. But that’s always the case. To help stay disciplined, it’s important to keep in mind that the market already reflects whatever concerns you may have.

Finally, remember this further advice from Warren Buffett: “The most important quality for an investor is temperament, not intellect.”

The inability to control one’s emotions in the face of uncertainty, and clarion cries of overvaluation, help explain why so few investors earn market rates of return and thus fail to achieve their objectives.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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