Valuation-Informed Indexing #160

by Rob Bennett

Saving is hard.

Investing is scary.

That’s what most people think.

I think most people are wrong on both points. I believe that the reason why most people are wrong on both points is that the experts who offer saving and investing advice have not to this day given sufficient consideration to insights developed in the behavioral finance school of thought.

The behavioral finance school argues that the ability to do numerical calculations is not what distinguishes those who are good with money from those who are not. It is human emotions that are most important. It is how the conventional saving and investing advice affects us emotionally that makes most of us bad at saving and afraid of investing.

In both cases, the big problem is that we humans focus too much on the short-term. We want to succeed at both saving and investing. But we give excessive weight to short-term feedback that misleads and discourages us.

Say that you are trying to save more. The key to success is to reject temptations to spend. The reason why most of us find that hard to pull off is that all decisions to spend offer at least some positive short-term feedback. Even the most wasteful spending makes your life better in some small way.

You cannot say that about saving. Most of us save to finance an old-age retirement, a saving goal that does not provide any tangible benefits for 10 or 20 or 30 or even 40 years. In the contest between saving and spending, spending is always the better choice in the short-term.

I believe that the answer is to direct our saving energies toward goals that can be achieved in five years or less. If your goal is to cut your mortgage in half within five years, you can see steady progress made on a monthly basis toward a goal that provides a nice feeling of financial independence in not too long a time.

Your desire to enjoy that good feeling can help you see that the value proposition offered by a lot of spending options is not that strong. Savers who pursue financial freedom goals that can be achieved within five years save more effectively than savers who make an old-age retirement their primary saving goal even when they are in their 20s and 30s and 40s.

Those seeking to become effective investors face a similar (but also somewhat different) problem.

The academic research shows that there is a huge benefit that follows from being willing to defy the conventional advice and engage in long-term timing (changing your stock allocation in response to big valuation shifts with the understanding that you may not see benefits for doing so for as long as 10 years). Long-term timers reduce the risk of stock investing by 70 percent by making the simple decision to take price into consideration when setting their stock allocations. Valuation-Informed Indexers can realistically expect to be able to retire five to ten years sooner than their Buy-and-Hold counterparts.

Everyone wants to reduce the risk of stock investing. Everyone wants to be able to retire early. So why is it that there is even one investor who still prefers Buy-and-Hold to Valuation-Informed Indexing?

Buy-and-Hold often appears to offer better results in the short term.

The research shows that, when stocks are priced as they were in 2000, the likely long-term return is a negative number. If some other investment class offered a negative return, people would disdain it. People complain when certificates of deposit or money market accounts offer returns of less than 1 percent.

But rarely do you hear complaints from Buy-and-Holders when stocks are priced to provide low or negative returns for many years to come. Why? What’s the difference?

The difference is that stocks can offer weeks or months or even years of good returns during extended time-periods in which the long-term return is a negative number. We are priced today to see a 65 percent price crash sometime over the next year or two or three. But most stock investors tune out the research that points to that result. They like the short-term gains they have experienced during the small bull market that has come to dominate for a few years of a secular bear market.

The short term doesn’t matter for most investors. Most investors are seeking to finance old-age retirements. So how stocks do over the course of a few years just doesn’t make any difference. But it is human nature to draw comfort from those numbers. Most investors view the numbers on their portfolio statements as “real” and the findings of the 32 years of academic research showing that Buy-and-Hold strategies never work in the long run as pure theory.

Savers need to turn their attention to the short-term. Not because the long-term doesn’t matter. Because it is short-term feedback that motivates us and the big problem in saving is the lack of motivation for the task that most of us feel today.

Investors need to turn their attention to the long-term. Because the short-term results evidenced on their portfolio statements are misleading. Whenever those short-term results make you the happiest, the conditions are set for a long-term catastrophe. Investors who want good long-term results need to look at long-term feedback (which is available only in the academic research and in the historical data, never in the numbers in one’s personal portfolio statement and rarely in the advice heard on television or in magazines or at web sites) to to learn what really works for that purpose.

Rob Bennett has recorded a podcast titled Recessions Don’t Cause Market Turmoil, Market Turmoil Causes Recessions. His bio is here.