by Rob Bennett
Say that you believe that what Shiller showed was so really is so. Valuations affect long-term returns.
What follows from that?
If this is so, then the market is not efficient. An efficient market is one that takes into consideration every factor bearing on the market price when setting the market price. Overvaluation is a factor bearing on the market price. Stocks do not perform as well on a going-forward basis starting from times at which they are overvalued. If this factor were given consideration, it would send prices downward until prices reached fair-value levels. Overvaluation is a logical impossibility in an efficient market.
Yet we have overvaluation. So we know that the market is not efficient.
The market should be efficient. Investors should be investing in their own best interests. It is in the best interests of all investors to price stocks properly. So how is it that the market has remained inefficient?
There’s some sort of funny business going on here! I’m sure of it!
What’s going on is that we are fooling ourselves.
Investors have the power to set stock prices wherever they please. We are all worried about our retirements. So we all are tempted to pretend that our stock portfolios are worth more than what they really are worth. So we set prices at levels higher than the proper level. That’s called “overvaluation.”
But how does it remain in effect?
Shiller reports on the level of overvaluation at his web site. Given that it is in investors’ best interest to make informed decisions, wouldn’t they go to the site and check the level of overvaluation before setting their stock allocations? There’s money involved. What could possibly stop them from doing so?
That’s the only possibility. Shiller’s research is telling us that investors deliberately act contrary to their self interest by ignoring stock valuations when setting their stock allocations. There is no rational justification for doing so. What are the other possibilities?
You could say that there is an emotional justification. Our desire to believe that our retirement accounts are in better shape than they really are in is a childish desire for a magic solution to a serious adult problem. It is not part of a reasoning process. It is the product of an emotional urge for a quick fix.
But how do we get others to go along?
If stock experts were to explain the realities, our efforts to indulge in emotional investing would fail. If the financial press were to report on the realities, our efforts to maintain a belief in fantasy prices would be of no avail. If our friends and neighbors and co-workers laughed at us when we described our plan to stay at the same stock allocation no matter how dangerous prices became, we would feel ashamed of our Get Rich Quick thinking and would vow to make more realistic choices in the future.
How do we keep the fantasy going during bull markets? That’s the great unanswered question of stock investing.
We create a Social Taboo that punishes those who tell the truth about stock investing in clear and blunt and direct language. Humans are social creatures. Faced with enough social pressure not to spill the beans, most of us will agree not to do so.
We now have a means of identifying when stock investing has become dangerous. When a Social Taboo is in place blocking people from talking openly about the effect of valuations on long-term returns, stock investing is dangerous.
You won’t need to participate in many internet discussions of investing to determine whether a Social Taboo is in place or not. Social Taboos need to be enforced. They always reveal themselves.
I have an article at my web site that sets forth 101 comments of participants in discussion-board conversations who were unhappy with the Social Taboo being enforced on the boards at which they were participating. Investing experts should be studying board interactions of this type. They tell a story that you don’t learn about from reading the conventional research in this field.
Not everything there is to know about stock investing can be reduced to numbers. Lots of us are uncomfortable today digging deep into what is going on with investors’ emotions. That’s the future. Investing is primarily an emotional game. We need to work up the courage to supplement our analyses of numbers with frank examinations of the emotions that are often the driving force behind the numbers.