by Rob Bennett
The Buy-and-Hold Model for understanding how stock investing works is the dominant model of today. I recommend that the Buy-and-Hold Model be replaced with the Valuation-Informed Indexing Model. But you know what? It’s not necessary that any model be dominant. We might be better off just leaving it an open question.
To explain why this has become a big deal, I need to provide some background on how our knowledge of how stock investing works has advanced over the years.
Prior to the 1960s, there was no systematic study of how the stock market works. Smart people like Benjamin Graham offered scores of powerful insights. But stock investing was not a subject of much serious academic study. So all insights were one-offs. They were not combined in a single, sustained narrative explaining all the ins and outs of how and why the stock market does all the things it does.
That changed with the development of University of Chicago Professor Eugene Fama’s Efficient Market Theory. Regular readers know that I view the theory as gravely flawed. That said, however, I also view the theory as having represented a huge step forward. You don’t have to get everything right to generate important insights. There would be no Valuation-Informed Indexing today had Fama not stepped forward with the Efficient Market Theory back in the 1960s.
The tragedy is that advocates of the Efficient Market Theory got so hung up on being perceived as having figured out everything there is to know about stock investing that they blinded themselves to the next set of important insights, those that followed from the 1981 discovery by Yale Economics Professor Robert Shiller that valuations affect long-term returns.
Had we combined Shiller’s insights with Fama’s insights when it first became possible to do so, we would all be riding high today. We would have reduced the risk of stock investing by 80 percent. We would not be in an economic crisis. We would instead be enjoying the greatest surge of economic growth yet seen in U.S. history. It was by sticking with the failed theory for three decades after its failure became evident that we got ourselves in such a mixed-up, upside-down situation.
Why did we do it?
Fama’s followers are smart people. They were capable of seeing when Shiller published his breakthrough research that the game was up. Why didn’t they quickly get about the business of modifying their ideas to make them relevant and workable under the new scheme?
Excessive human pride is part of the story, obviously. We humans don’t like to admit it when we discover we have made mistakes. We often cover up our mistakes rather than correct them, creating far bigger troubles for ourselves than those we would need to cope with if we quickly went about the business of getting things back on track. Ask Former President Nixon!
I believe that there is more than just false pride at work here, however. I believe that the Buy-and-Holders (“Buy-and-Hold” is the name we give to the strategies that follow from a belief in Fama’s efficient market concept) are reluctant to acknowledge the challenge to their beliefs presented by Shiller’s work because to accept that they made such critical errors on such fundamental points would put their entire model in jeopardy.
All that is so. But it is not at all a bad thing!
Tearing down the Buy-and-Hold model permits us to erect a new model (Valuation-Informed Indexing) in its place. The new model will obviously retain the features of the old model that have stood the test of time. By tearing down the old model and participating in the effort to erect a new one, the Buy-and-Holders protect those of their ideas that retain their power even today. By failing to tear down the old model, and thereby bringing on an economic crisis, the Buy-and-Holders are only creating animosity for their entire project, a project that contains a significant amount of good to go along with the significant amount of bad that requires that the model be brought down.
Why don’t people see this? Why do people cling so stubbornly to the past when faced with an opportunity to choose instead a future that objectively looks pretty darn inviting?
To tear down a model for understanding how the world works is a disorienting experience.
I can think of two other scientific controversies raging today in which we see similar levels of defensiveness evidence themselves. There are climate change believers and there are climate change skeptics. There are Intelligent Design believers and there are Intelligent Design skeptics.
The thing that causes most of the friction in all three cases is the feeling among some that we must have answers today. We must either declare all the findings of the climate change scientists true or declare all of those findings false. We must either accept that Intelligent Design raises questions about some aspects of the evolution theory or we must reject out of hand the idea that any questioning could ever be possible. We must either stomp out discussion of any challenges to Buy-and-Hold strategies or we must throw out everything we thought we knew about stock investing and begin our investigations anew with a clean slate.
I favor a less dogmatic approach.
I believe that Shiller’s ideas will prevail. My take is that they have already prevailed in an intellectual sense.
But it doesn’t worry me even a little bit that many smart and good people remain loyal to Buy-and-Hold to this day. What we need is a debate. We need to get people talking about the pros and cons of both Buy-and-Hold and Valuation-Informed Indexing. We want to have everyone feeling free to say precisely what he or she believes. It is through the interaction of different viewpoints that we will continue to make important advances.
I believe in Valuation-Informed Indexing. It doesn’t follow that you must. It might work out better for both of us if you do not. The less we agree on, the more we have to discuss, and the more we discuss, the more we are likely to learn.
Buy-and-Hold is dead!
We need quickly to replace it with —