by Rob Bennett

It seems strange to us that there was a time when most people thought the world was flat or that there was a time when most people thought that the sun revolved around the earth. The full reality is that our way of thinking about these matters no doubt seemed strange to those who held the earlier views when they were first exposed to it. We become so accustomed to one way of thinking that we come to believe that it is the only right way of thinking. But of course that often turns out not to be the case.

I believe that we are today in the early days of a revolution in our thinking about how stock investing works. When enough of us become comfortable with the new ideas, we are going to see a huge burst of economic growth, an advance forward strong enough to make us all forget about the pain of this economic crisis (which I expect will have to get pretty bad before enough of us will be willing to open up to the exciting new possibilities). I often find myself wondering what it is that makes it so hard for so many to give up on the old model of understanding stock investing (Buy-and-Hold) and embrace the new model (Valuation-Informed Indexing).

Imagine that your mind was a blank slate re investing, that you had never read a book or a magazine article or a study. What would you intuitively believe: (1) that the value proposition of stocks changes with changes in the price at which they can be purchased?; or (2) that the value proposition of stocks is always pretty much the same and that, thus, it is reasonable to remain at the same stock allocation at all times (that is, to follow a Buy-and-Hold strategy)?

I think it is safe to say that 90 percent of the population would say that the intuitive belief is that the value proposition of stocks is ever-changing and that we all should be changing our stock allocations to keep our risk profiles roughly constant despite changing valuation levels. Today’s reality, though, is that 90 percent of the population has bought into the Buy-and-Hold claim that there is no need to do so. Huh? What’s up with that?

One of the things that I think is going on is that people are giving the Efficient Market Theory (the intellectual construct behind the belief that there is no need to adjust one’s stock allocation regularly)  credit for explaining what would otherwise remain a mystery — the fact that short-term timing (changing your allocation with the expectation of seeing a benefit within a year or so) does not work. So those of us who want to move people away from Buy-and-Hold and toward Valuation-Informed Indexing are going to need to offer an alternative explanation.

Short-term timing should work.

Say that stock prices have reached insanely high levels, as they did in January 1996. Logically, they should be headed downward. Those who went to low stock allocations in early 1996 should have been rewarded for doing so in late 1996. But  they weren’t. It was those who went with high stock allocations (those who ignored valuations when setting their allocations) who were rewarded in 1996, 1997, 1998, and 1999.

That’s a fact that those of us arguing for valuation-informed strategies need to come to terms with. It’s a fact that impresses those who favor Buy-and-Hold strategies.

The Efficient Market Theory offers a plausible explanation for why this would be so. It posits that all knowledge about how stocks should be priced is built into the price at all times. Thus, the market price is at all times a rational price and a highly informed price. To time the market successfully, an investor needs to possess insight superior to that of the market as to what the market price should be. That’s a tall order if the market price is perfectly rational and perfectly informed.

The trouble is — if the market price were perfectly rational and perfectly informed, long-term timing (changing your allocation in response to valuation changes with the understanding that you may not see a benefit for doing so for as long as 10 years) would not work either. And Shiller’s research shows that it does. So we know that the market is not efficient.

How, then, do we explain the futility of short-term timing?

It could be that short-term price changes are unpredictable not because the market is highly rational but because it is highly irrational. You can’t beat the market if it is so rational that you cannot get an edge. But you also cannot beat the market if it is so crazy (in the short term) that all the analysis in the world does not give up a clue as to where it is headed.

The evidence of today is that the market is efficient/rational in the long run but inefficient/emotional in the short run. Our explanation of why short-term timing doesn’t work is the one that Bill Joel put forward in his song “Moving Out” — You should never argue with a crazy ma, ma, ma, ma, ma, man!

Perhaps we should be speaking not of the Efficient Market Theory but of the Emotional Market Theory.

Rob Bennett offers six unconventional mid-life career change tips. His bio is here.