While market valuations can signal future performance, the practical application of market timing often leads to lower returns and missed opportunities.
The Seduction of Valuation Metrics
Even the most disciplined index investors occasionally find themselves tempted to pull back when markets hit record highs or volatility spikes. This impulse is often fueled by a kernel of truth: when markets are expensive, future returns tend to be lower. The most reliable metric we have for this is the Shiller CAPE, or cyclically adjusted price-earnings ratio. Historical data suggests a clear relationship where the most expensive stocks eventually yield lower returns than the cheapest ones.
However, this relationship is often a trap for the unwary investor. Much of the data supporting market timing suffers from significant hindsight bias. When we look back at a century of data, we are sorting stocks based on information a real-time investor wouldn't have. What looks expensive today might look remarkably cheap relative to the valuations of the next decade. When you adjust for this and only use the data available to an investor at a specific moment in time, the predictive power of valuations becomes much weaker.
The Momentum Problem
One of the greatest challenges in using signals like the Shiller CAPE is that expensive markets can stay expensive for a very long time. Valuations can drift higher for years or even decades. If you sell because stocks look pricey, you are essentially betting against momentum—the well-documented tendency for assets that have been rising to continue rising. This is why timing strategies often underperform during long bull markets; they keep investors on the sidelines while the market continues to climb.
The historical record of timing is mixed at best. Research from AQR found that while a valuation-based timing strategy added value from 1900 to 1957, it significantly underperformed from 1958 through 2015. During the latter half of the century, stocks remained generally expensive relative to their past, causing market timers to be chronically under-invested. Without the benefit of hindsight, it is nearly impossible to categorize a market as definitively 'cheap' or 'expensive' until the opportunity has already passed.
The Danger of Missing the Best Days
The math of market timing is further complicated by the fact that the vast majority of stock market returns are concentrated in a tiny handful of trading days. If you are out of the market trying to avoid a crash, you risk missing the sudden, sharp recoveries that drive long-term wealth. For example, in the Canadian market from 1977 through 2018, the index returned nearly 10% annually. Missing just the single best trading day in that 40-year span drops the return significantly; missing the 15 best days drops the annualized return by over 2%.
This concentration of returns means that the cost of being wrong is much higher than the benefit of being right. To successfully time the market, you must make two perfect decisions: you have to know exactly when to get out, and you have to know exactly when to get back in. If you hesitate during the recovery, you can permanently impair your portfolio's growth. As Nobel Laureate Daniel Kahneman has noted, the world is not regular enough for anyone to develop true expertise in predicting stock price movements.
The Psychology of the Lump Sum
The urge to time the market is strongest when an investor is sitting on a large lump sum of cash. The fear of seeing a lifetime of savings drop by 10% the day after it is invested is a powerful psychological deterrent. Many turn to dollar-cost averaging—investing the money in increments over several months—as a way to mitigate this fear. While this is a systematic approach, it is important to recognize it for what it is: a form of market timing that assumes the market will offer a better entry point later.
Statistically, dollar-cost averaging is suboptimal. Research from Vanguard across multiple decades and geographic regions shows that lump-sum investing beats dollar-cost averaging about two-thirds of the time. This is because markets tend to go up more often than they go down; by delaying your entry, you are simply taking risk later and missing out on the market's natural upward drift. If you must use dollar-cost averaging to manage your anxiety, it is better than staying in cash indefinitely, but it is rarely the path to the highest return.
The Reality of Consistency
Ultimately, successful market timing requires a level of consistency that even professional managers fail to achieve. Beyond the difficulty of the predictions themselves, the strategy incurs higher trading costs and potential tax liabilities that further erode any marginal gains. John Bogle, the founder of Vanguard, famously remarked that in fifty years, he had never met anyone who could time the market successfully and consistently, nor did he know anyone who knew anyone who could.
The market will always feel uncertain, and record highs will always feel like a precarious place to invest. However, feelings of uncertainty are not a sound basis for financial strategy. For the long-term investor, the most reliable path is not to wait for the perfect moment, but to recognize that time in the market is vastly more important than timing the market. The data suggests that the best time to invest was yesterday; the second best time is today.