Part 5: Market Timing and Market Equilibrium
Part 4 discusses the effects of rebalancing in various markets but does not provide insight that can help an investor evaluate the different portfolio risk-management approaches. This part takes a look at the concept of market equilibrium and the way that investor portfolios as a whole must change as the stock market rises and falls.
A market equilibrium is simply the scenario of a market in which prices have adjusted to the point that there is a balance between buying and selling – which means that there is a balance between the supply and demand of the assets being traded in that market. When the equity market is in equilibrium it means that for every share of stock that exists there are exactly enough investors who wish to hold that stock at its current price – no more and no less.
Although a market equilibrium is a theoretical concept, on a practical level it is a reasonably accurate description of the U.S. stock market. Specifically, at each point in time all investors combined have a portfolio allocation to equities (e.g., say 35%) with which they are satisfied. Clearly, that combined portfolio allocation must match the total market value of all equities expressed as a percentage of all asset classes. Equity values rise and fall to balance the demand for shares with the supply of shares.
Note that the percentage of all investments represented by equities must rise and fall as the stock market rises and falls relative to other investments. Roughly, if the stock market at the depth of the 2008 financial crisis represented 25% of all investments, and if the stock market then doubled in value while all other investments remained constant, the percentage that equities represent would have to rise to 40% to reflect their increase in value. Note that the 40% value after equities doubled (rather than a 2 x 25% = 50% value) is found as 50%/1.25. The 1.25 takes into account the effect of the equity price increases on the aggregation of all investments combined assuming that the other investments (bonds) did not change in value.
The idea that equity as the percentage of all investments must rise and fall with the stock market has a very important implication. Using the rise from 25% to 40% in the previous paragraph to illustrate – the implication is that investors as a group must move from having an average equity risk exposure of 25% to having an average risk exposure of 40%! Investors as a group in this example – including buy-and-hold investors – are dramatically increasing their risk exposures.
This discussion has made several assumptions. It has ignored the idea that the prices of other securities such as bonds and real estate are changing at the same time that the equity prices are changing, and it assumes that corporations are not issuing lots of new stock or repurchasing lots of old stock. But the general principle is unaffected by these assumptions.
The general principle is this: investors as a group will have a much higher concentration of equity in their portfolio when the stock market reaches a peak than when the market reaches a bottom. In other words, going with the crowd will place an investor in the wrong place at the wrong time.