by Rob Bennett

Going back to the earliest days of stock analysis, there have been two major branches of thought: (1) those who favored Fundamental Analysis, looking at how the underlying companies are likely to perform; and (2) those who favored Technical Analysis, looking at how investors’ perceptions of stocks (and this the prices they assign to them) change regardless of the economic realities. Valuation-Informed Indexing is the first model (so far as I know — please let me know if I am wrong about this) that effectively combines the insights of the two models.

Pretty much everyone agrees that both those arguing for Fundamental Analysis and those arguing for Technical Analysis have good points to make. However, most investors feel compelled to join one camp and reject the other. The task of combining these two ways of looking at stocks (one focused on numbers and rationality and the other focused on emotions and psychology) has long seemed a difficult, if not impossible one.

Valuation-Informed Indexing combines the two schools of thought by positing that it is human emotion that sets the price assigned to the stock market in the short term and the economic realities that assigns the price assigned to the stock market in the long term. The puzzle raised by this attempted integration of the two primary branches of investment analysis is: How does the market know when it is time to shift from a focus on emotion to a focus on rationality?

My thought is that the explanation lies in developing an appreciation of the strange aspect of human psychology that permits us both to “know” and ‘not know” the same thing for a stretch of time.

A friend of yours has become an alcoholic. He has lost his wife, his family, his house, his health, his job, his income and his self-respect. You begin making the case for giving up the drinking but stop when you realize he knows everything you could say before you say it. It is obvious that he knows. He becomes intensely defensive when any of his failings are brought up. He swears to you that he can give up the drink any time he wants, that he has things under control.

Do you take him at his word?

You cannot. His anger tells you that he is kidding himself, that these words are not trustworthy. But they also tell you that he knows that he needs help. The same words say two opposite things, depending on whether you listen to the literal words or the emotion producing the words.

The full truth is that your friend knows intellectually that he needs help and he knows emotionally that he does not want to give up drinking. He is not capable of thinking or talking straight on his problems because he at the same time both knows and doesn’t know how bad it is.

So it is with stock investors.

We all “knew” in January 2000 that there was going to be a terrible price to pay for our having permitted stocks to become overvalued to the tune of $12 trillion. We were all walking around with portfolios priced at three times their fair value and spending as if those portfolio figures represented real wealth. We knew intellectually that we were wrong to permit the craziness to continue. And we knew emotionally that we did not by any means want it to stop.

To know two opposite things at the same time creates a volatile situation. A person’s actions can reflect only one set of beliefs at any given time. In January 2000, we acted as if the insane overvaluation did not matter, as if it was all going to turn out different this time. But we are intellectual creatures as much as we are emotional ones. Sooner or later the power was going to swing to our intellectual side and we were going to take actions to cause the rational belief (that the portion of our portfolios rooted in overvaluation was Funny Money fated to be blown away in the wind) to become dominant.

Our economic crisis was similar to the sort of crisis that is faced by a drunk trying to go sober. It felt terrible even though it represented an attempt to return to healthy stock valuations. One day, $12 trillion in overvaluation seemed fine to most of us, even though there was no rational defense that could be put forward for the stock prices that applied at the time. Not too long later, stocks were on their way to more reasonable price levels. We were sick of being drunk.

So it is silly to attempt to assign economic explanations for the crash. The things that are often pointed to set it off in the way that an alcoholic’s experience of nearly getting hit by a car might cause him finally to face facts. The real reason why an alcoholic tries to go sober is not that he was almost hit by a car but that there is a desire within him to live a better life that finally comes out. We all always wanted to do something about that $12 trillion we had borrowed from future investors to pay for the fun times we enjoyed in the late 1990s. It just took us eight years to work up the courage to get serious about the idea we had been tossing around in our collective head for some time.

We’re playing mind games with ourselves. That’s what is going on. That’s the technical analysis side of things that cannot be ignored. That’s what stock investing is all about.

Yet it is not only about mind games. The focal point of the mind games is the economic realities. It is those economic realities that we are always either working hard to ignore or working hard to recognize. That’s the fundamental analysis side of things that also cannot be ignored.

Buy-and-Hold offers great insights re the rational side of things. But it is a dangerous model because it is a numbers-based model that ignores the emotional side of things that is at least 50 percent of the game. Because Buy-and-Hold ignores the effect of human emotions on prices, it is a numbers-based model that gets all the numbers wrong!

To get the numbers right, we need to integrate analyses of both sides of the human personality, the rational and the emotional.

Rob Bennett writes on both the pros and cons of index investing. His bio is here.