Valuation-Informed Indexing #95
by Rob Bennett
The fellow who writes the Pop Economics blog (unfortunately, it is dormant for the time-being) is wise. When I had a discussion with him about the need for us as a society to make the transition from Buy-and-Hold to Valuation-Informed Indexing, he neither endorsed the idea nor rejected it. He focused on the practical problem that has been holding back this transition for 10 years now.
We need to find a way for the Buy-and-Holders to save face.
It’s not that the case for Valuation-Informed Indexing is not strong enough. It’s too strong! If Valuation-Informed Indexing only increased returns a small bit or diminished risk a small bit, the Buy-and-Holders would jump on it. Everyone wants to achieve higher returns while talking on less risk.
Valuation-Informed Indexing is too large a jump forward. It makes the Buy-and-Holders feel uneasy to acknowledge that their strategies perform so poorly in the long run. It’s embarrassing! And the higher the mountain of research supporting Valuation-Informed Indexing over Buy-and-Hold grows, the worse the Buy-and-Holders feel. And the worse the Buy-and-Holders feel, the less inclined they are to acknowledge their mistakes.
Many of the “experts” in this field cope with this problem by downplaying the case for Valuation-Informed Indexing or by suggesting that Buy-and-Hold is not really so terrible. That’s not the way to go. Taking that path stretches out our pain. We need to move on. But we need to move on together. We need to bring the Buy-and-Holders aboard. We need to come up with ideas for helping the Buy-and-Holders save face.
Here are five ideas that I have come up with:
1. Pointing Out that Buy-and-Hold Provided the Foundation for Valuation-Informed Indexing
If you had asked me on the morning of May 13, 2002, what investing philosophy I believed in, I would have told you that I was a Buy-and-Holder. The idea of rooting one’s investing strategy in the academic research was the turning point. The Buy-and-Holders took us out of the Dark Ages. Valuation-Informed Indexing wouldn’t be possible but for all the good work done by the Buy-and-Holders for decades before we came along.
2. Pointing Out That the Mistake Made by the Buy-and-Holders Was a Perfectly Understandable Mistake
The thing that the Buy-and-Holders got wrong was their idea that it is not necessary for investors to change their stock allocations in response to big valuation swings. There is zero support for this idea in the academic research. So how did they came up with it? The Efficient Market Hypothesis was widely accepted in the days when Buy-and-Hold was being developed. It wasn’t until Shiller published his 1981 research showing that valuations affect long-term returns that the hypothesis was discredited in the literature. It is hardly surprising that the people developing an investing strategy in the early 1970s failed to include research findings advanced in the early 1980s into their formulation!
3. Pointing Out that the Efficient Market Hypothesis, While Discredited in Its Original Form, Has Generated Important Insights All the Same
Shiller discredited the Efficient Market Hypothesis. So we need to move on from Buy-and-Hold. But we don’t need to make those who once believed in the Efficient Market Hypothesis feel bad about it. The full truth is that Eugene Fama almost got it right. The market is indeed inclined to get the price of stocks right. The market does indeed want to be efficient. Paradoxically, the thing holding us back is Buy-and-Hold. So long as investors do not see a need to lower their stock allocations when prices rise too high, the market can never be efficient. But once we begin providing tools to investors to help them make appropriate allocation adjustments, there is every reason to believe that market efficiency will become a reality. Thanks, Eugene Fama! Thanks, Buy-and-Holders!
4. Pointing Out That, While Buy-and-Hold Did Not Live Up to Its Promise, Indexing Exceeded Its Promise
Most Buy-and-Holders advocate indexing for the typical middle-class investor. The Buy-and-Hold approach to indexing has destroyed more middle-class wealth than any earlier idea in the history of personal finance. But indexing has held up under intense scrutiny and then some! Indexing works. It’s smart investing, it’s simple investing, it’s safe investing (for those open to changing their stock allocations in response to big valuation swings). Decades from now, few will look back at the Buy-and-Holders and chastise them for their mistake about the need to be willing to change their stock allocations to keep their risk profiles roughly constant. They will look back to them with gratitude for their efforts to develop and promote the indexing concept.
5. Pointing Out That Valuation-Informed Indexing is the Fulfillment of Bogle’s Quest to Help Investors “Stay the Course!”
John Bogle is the king of Buy-and-Hold. Bogle has said that his most important piece of advice is his injunction to investors to “Stay the Course!” Bogle has been proven wrong in his suggestion that it is possible to do this while sticking with a single stock allocation while valuations shift wildly. But Bogle’s idea of Staying the Course is 100 percent in tune with the principles of Valuation-Informed Indexing. We change our stock allocations because we know we must do so to have any hope of keeping our risk profiles constant. To Stay the Course in a meaningful sense, investors must switch from Buy-and-Hold to Valuation-Informed Indexing. It’s the king of Buy-and-Hold who focused our attention on this critical aspect of the investing project.
Buy-and-Hold is Dead.
Long Live Valuation-Informed Indexing, the New Buy-and-Hold!