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The agony of waiting

Many investors sitting on cash should not wait for a market correction before investing
October 5, 2017

It’s a dilemma many of you have: you have cash to invest but you feel stock markets are expensive, so should you wait for a correction?

The answer, according to new research, is no. Victor Haghani and James White of London-based fund manager Elm Partners looked at what happened to US shares in the three years after they had become expensive, as gauged by the cyclically-adjusted price/earnings ratio (Cape) on the S&P 500 being a standard deviation above its long-run average.

They found that, over the past 115 years, shares fell 56 per cent of the time from such a starting point, giving the patient investor a 10 per cent gain from waiting. However, in the other 44 per cent of cases, prices continued to rise, costing the investor an average lost return of 30 per cent. This is what’s happened recently: the Cape signaled that shares were expensive years ago, but they’ve continued to rise. On balance, then, waiting for a correction is a bad idea.

If this seems surprising, it might be because we confuse two different ideas. Over any period, there’s a high chance of the market falling significantly. This gives us the impression that it’s worth waiting for a correction. But this isn’t the question we face. The question is: will shares fall from this point? The fact that the market looks expensive isn’t sufficient to tell us this. Maybe high valuations are justified today by low interest rates and/or the fact that US companies have more monopoly power and hence more sustainable profits than they used to have. And even if this isn’t the case, irrationally expensive markets can always become more expensive.

Worse still, there’s the danger that the investor who waits for a correction will lose patience and buy at higher prices just before a correction. Does it therefore follow that we should never wait for a correction? Not necessarily. What we face here is a choice between two different types of cost.

If we invest and the market falls, we suffer an out-of-pocket cost. If we don’t invest and the market rises, we instead suffer an opportunity cost. We’re no poorer (except to the extent that real interest rates are negative), but we miss out on profits. Economists often urge people to treat opportunity costs and out-of-pocket costs the same. This is often correct. But I wonder: is it in this case?

If you’re well short of your target level of wealth, then the opportunity cost does matter. Missing out on rising prices will mean having to save more in future to make up your wealth. If, however, you are around your target level, things are different. Missing out on a big rise would be a matter of regret, but an actual loss would force you into possibly painful changes of plans, such as delaying retirement. For you, staying out of the market and incurring an opportunity cost might then be the least bad mistake you can make.

The point here is simple. The question of whether we should wait for a correction isn’t simply a matter of futurology. It also depends on your tastes, situation and objectives. And we should always ask: which mistakes are we most keen to avoid?