We Don’t Understand What the Word “Overvaluation” Means

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Valuation-Informed Indexing #132

by Rob Bennett

What does the word “overvaluation” mean?

The truth is — Most of us don’t know. It’s not because we are not smart enough or because the concept is hard to understand. It is because we would rather not know. We avoid thinking about the question. It is the job of every expert in this field to help us overcome our reluctance to understand the meaning of this word.

I say that it was the promotion of Buy-and-Hold strategies that caused the economic crisis. Buy-and-Hold teaches that valuations don’t matter, that it is okay for investors to stay at the same stock allocation at all times. Because none of us were exercising price discipline, the market became overvalued by $12 trillion in early 2000 and the loss of that amount of spending power caused tens of thousands of businesses to fail and our economy to collapse.

Buy-and-Holders don’t agree. But they have a very hard time articulating their case. I ask them all the time to tell me why they do not agree. The only answer they give is: “Well, no one else says that.” That’s so. But that response offers no intellectual challenge to the logic chain. It’s just another way of saying “I don’t like hearing that.”

I think it would be fair to say that the widespread popularity of Buy-and-Hold strategies was obviously the primary cause of the crisis. But it is certainly true that not many people say this in clear and firm and confident terms. There was a commission formed to examine the crisis and report on its causes. The commission’s report didn’t mention the $12 trillion in spending power we lost as a result of our creating $12 trillion worth of imaginary wealth in the Buy-and-Hold years.

We don’t understand what the word means. In a technical sense, we know. But it makes us uncomfortable to ponder these questions. So we put them to one side. We can all offer reasonable definitions of the words. But we act as if those definitions are not valid. We kinda, sorta know what the word means. But we ignore what we know. So in a real-world sense, we don’t know.

I’ve asked hundreds of Buy-and-Holders what they believe the word “overvaluation” means. I always hear the same general answer.  Most acknowledge that overvaluation exists and that the word signifies a mispricing of stocks. Push for more specifics and you get the glassy-eyed look. Asking stocks investors what should be done about overvaluation is about as fruitful an endeavor as asking politicians what should be done about the Federal budget deficit. It is an urgent matter that must be addressed! Now can we all kindly turn our attention to other matters?

Vanguard Founder John Bogle says that there are times when investors might want to consider lowering their stock allocations by up to 15 percent in response to concerns about overvaluation. Why the 15 percent maximum allocation change? He doesn’t say. And none of the investors following his investment advice ask the question of him. They like it that he says that nothing more than a 15 percent change should be considered and that even that big a change is not required. The suggestion here is that overvaluation is not a big deal.

Buy-and-Hold is a research-based strategy. So you would think that the Buy-and-Holders would turn to research to determine whether the proper allocation change should be 5 percent or 15 percent or 25 percent or 65 percent. Using data for guidance on investing decisions is what Buy-and-Hold is all about. No study has ever been published on this question, however. A curious mind cannot help but wonder why.

Actually, there is one study on the question. It is ignored by the Buy-and-Holders. They don’t like seeing what the study says. They prefer to shoot from the hip when identifying the right amount by which to change their stock allocations in response to various amounts of overvaluations. Specifics are upsetting.

The problem here is not that investors are dumb. Investors are smart. Our minds are fast enough to see that, if overvaluation is a big factor, our portfolios are not worth what we pretend they are worth during bull markets.  What a drag! Let’s say that there are circumstances where it is an important enough factor to justify a 15 percent allocation change but never anything more than that. That statement sounds scientific — it identifies a particular allocation change. But it doesn’t offer any means of testing whether the 15 percent recommendation is a reasonable one or not. Perfect!

A fellow sent me an e-mail that said: “It amazes me how so many people can say ‘valuations matter,’ yet in the next breath they’ll say we should ignore valuations.” Precisely so! It takes a great deal of intelligence for us to keep ourselves so in the dark as we have managed to keep ourselves re the overvaluation matter.

I don’t like to upset people. I want to leave things on an encouraging note.

After the next crash, there won’t be any purpose served anymore by our unwillingness to understand the meaning of the word “overvaluation.” So we will all be taking a serious look at the 30 years of academic research that tells us things about this question that no group of investors who came before us was privileged to know. The walls of ignorance that we use to protect ourselves from learning about the most important issues in stock investing are in the process of falling down.

Rob Bennett created the first retirement calculator that gets the numbers right (because it contains an adjustment for valuations). His bio is here.

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