by Rob Bennett
This column argues for the model for understanding how stock investing works (Valuation-Informed Indexing) rooted in the research of Yale Economics Professor Robert Shiller over the model (Buy-and-Hold) rooted in the research of University of Chicago Economics Professor Eugene Fama. To explain why Valuation-Informed Indexing is superior, I often need to point out that Buy-and-Hold is rooted in Get Rich Quick thinking and that it is the promotion of Buy-and-Hold that was the primary cause of the economic crisis.
Buy-and-Holders often object. They point out that Buy-and-Hold was the first model rooted in academic research and the historical data and, thus, was an attempt to avoid Get Rich Quick thinking. Get Rich Quick schemes are rooted in emotion. The idea with Buy-and-Hold was to root one’s investing strategies in objective research and thereby to avoid falling prey to the emotional pressures that have ruined so many stock investors of the past.
My response is to agree that this indeed was the purpose that was being pursued when Fama and Burton Malkiel (author of A Random Walk Down Wall Street) and Vanguard Founder John Bogle began making the case for Buy-and-Hold in the early 1970s. I view Buy-and-Hold as a huge advance over what came before. My claim is not that Buy-and-Hold started out as a Get Rich Quick scheme but that it became one after Shiller published his 1981 research showing that valuations affect long-term returns (thereby discrediting Fama’s Efficient Market Theory, the backbone of the Buy-and-Hold Model) and, rather than updating the model, the Buy-and-Hold advocates elected to engage in rationalizations of their decision to continue to promote the discredited model.
The thing that throws people is is that the question of whether the stock market is efficient or not is fundamental. Thus, getting this one right gives you a good chance of getting every other investing question right. But getting this one wrong gives you a good chance of getting every other investing question wrong.
If the market is efficient, Buy-and-Hold is the best investing approach ever developed by the human mind. I have no problem saying that. It really is an objective approach. So, if the Buy-and-Holders got the fundamental question right, I think it makes sense to go with what they say about asset allocation and retirement planning and risk management and all other sorts of topics.
My problem with Buy-and-Hold is that I don’t believe the market is efficient. There is now a mountain of research showing this. And, if the market is not efficient, Buy-and-Hold is not a little bit wrong. If the market is not efficient, the Buy-and-Holders are wrong about asset allocation, retirement planning, risk management and just about every other investing topic. Yikes!
Say that you were driving from Virginia to Philadelphia, and that, when you got to I-95, instead of taking it East you took it West. After driving for three hours, you would be three hours farther from your destination than you were when you started your trip. After driving six hours, you would be six hours of driving time worse off than when you started. After driving nine hours, you would have nine hours of driving time to make up before you would be back to zero. When a mistake goes uncorrected, it gets bigger and bigger and bigger over time.
We learned in 1981 that the market is not efficient. But we had already been driving for some time at that point. Fama had already performed his studies, Malkiel had already published A Random Walk Down Wall Street, Bogle had already founded Vanguard. The idea of acknowledging a mistake and turning back seemed too horrible to contemplate. So we kept driving and driving and driving and driving. In the wrong direction. We kept putting more and more and more and more miles between ourselves and our intended destination.
It’s sad. But it doesn’t help at all for us to ignore the reality of what we have done to ourselves.
Is it easier today to admit the mistake? It’s not. It’s harder. Now the mistake has brought on an economic crisis. Tens of thousands of businesses have failed because of it. Millions have lost their jobs because of it. There are signs that many Americans are beginning to lose confidence in their political system because of the fundamental mistake that has gone uncorrected for so long.
If only we could wave a magic wand that would take us back to 1981! The embarrassment that would have been felt then seems small when we consider the embarrassment we would feel coming clean about the mistake today. But there is no magic wand. The only options available to us today are to acknowledge the mistake at a time when we have to drive 900 miles to get back to our starting point or to put off doing so until a time when we will have to drive 1200 miles or 1500 miles or 1800 miles to get back to the starting point. So long as we continue driving in the wrong direction, the problem gets worse with time.
There’s an encouraging way to look at all this, however. While Buy-and-Hold has remained the dominant model for 30 years past the time it was discredited by the research, not all researchers have been going along with the conventional thinking. About 10 percent of investing professionals began pursuing Shiller’s insights in 1981 and have made impressive progress over the past three decades. When we reach the point where we can admit the error, the power of all of those insights becomes available to all of us.
We have lived through the most damaging three decades of investing advice in history. But we can turn things around quickly by coming as a society to a consensus that we very much need to hear the other side of the story, that we very much need to learn how stock investing works in a world in which valuations affect long-term returns and the market is most definitely not efficient.
Today’s hard times are the prelude to the greatest period of economic growth yet seen in U.S. history. Hold on just a little bit longer — If you thought our economy showed potential through all those years when we possessed only vague and ill-informed ideas re how stock investing works, you ain’t seen nothing yet!