Valuation-Informed Indexing #185

by Rob Bennett

It’s the Goon within us that draw us to Get Rich Quick strategies. He’s a selfish guy and a dishonest gut and it is my regular practice to urge you to keep your distance from him. He is dangerous. But the full psychological truth here is that there is a reason why that Goon spirit resides within us all. We can never fully extinguish him. The best way to protect ourselves from his worst tendencies is to make an effort to make peace with him.

The full reality is that most Goon inclinations serve at least some positive purpose along with the negative purpose that causes me to term them goonish.

We are inclined to focus on the short-term. It’s a bad idea. The best strategies only work in the long term and getting too concerned with short-term results can cause us to abandon them. So we really do need to resist this urge.

But perhaps the best means of resisting it is to understand the good in it and finding other avenues to achieve the positive aims. Why are our brains set up to engage in short-term thinking when making investing choices?

Long-term outcomes are just a bunch of short-term outcomes pieced together. We are drawn to focusing on the short term because all decisions are made in the here and now and it is important to make the right ones.

Our problem is that we let nominal prices distract us. Nominal prices are always misleading. Shiller’s research shows us that the market reveals the price of stocks to us in a two-step process: There is the nominal price and there is the valuation adjustment that must be made to the nominal price to reveal the true price.

Make that change and paying attention to the short term is no longer a bad thing. In 2000, stocks were priced at three times fair value. Investors who accepted the nominal price as real got themselves in a lot of trouble. If they had $200,000 of real value in their portfolios, they acted as if they had $600,000 of real value in their portfolios and made all sorts of inappropriate spending decisions. But, once the required adjustment is made, it becomes possible to use the pricing information available only in the short term to make decisions that work in the long term as well.

The Inner Goon is skeptical of new ideas. Shiller’s “revolutionary” (his word) findings were published 32 years ago and big names still promote Buy-and-Hold strategies to this day. That’s bad. Our skepticism is holding us back big time.

But skepticism itself is not a bad thing. The reality is that the Buy-and-Holders advanced many powerful insights. We want to be skeptical about challenges to those ideas. And once we come to accept the need to consider valuations when setting our stock allocations, we will want to be skeptical of challenges to the new orthodoxy as well.

If our minds become too flexible, we will find ourselves jumping from investing fad to investing fad. The idea that long-term timing is not required was a mistake. But it was a mistake that persuaded many good and smart people. We shouldn’t dismiss it too easily. I certainly wish that more people would question it more forcefully. But, trying to be objective about things, I can see that jumping from one core belief to its opposite should be done only with a great deal of caution.

The Goon voice says: “Don’t sell when the market goes bad.” That’s not good advice. If the market goes bad because it is overvalued, it likely will be going bad for a long time. It’s better to sell early in a secular bear market than it is to sell only after just about everyone else has done so, when prices are at their lows.

But the Goonish determination that insists that you never sell is rooted in something healthy. The market is always changing and we are tempted to change our strategies in response. The best strategies cannot work unless we stick with them long enough to pay off. So being pigheaded really can be a plus. We just need to learn how to employ the pigheadedness in a positive way. We need to take that pigheaded drive and use it to force us to always change our stock allocations in response to big valuation shifts rather than using it to force us never to do so.

The point here is that we need to forgive ourselves.

We caused this economic turmoil either by participating in the bull market of the late 1990s or by failing to speak up when we saw our friends and neighbors and co-workers participating in it. We are reluctant to learn lessons from a negative experience in which we were complicit. Our guilt isn’t spurring us to constructive action. It is paralyzing us.

We all need to develop more of a sense of humor about the role we played in bringing our economic system to its knees. Yes, we messed up, flawed humans that we are. But the full reality is that the same humans who caused the biggest bull market in history (and hence the biggest economic collapse in history if we don’t eventually take effective action to hold it off) also share a bit of the credit for the insights that permit us today to reduce the risk of stock investing by 70 percent.

Shiller did not produce his research in a bubble. He had help. All of us helped. Yes, even the Buy-and-Holders. Yes, even the Goon voices within us all.

We’re mess-ups. And we’re heroes. Both things are so. Each of us needs to defeat his or her inner Goon. But not by yelling at it. We defeat our inner Goon by listening to it, by trying to understand its message for us. We overcome our Goonishness by understanding where it comes from, why it exists in the first place, and how we can put the energy that animates it to good and positive and constructive and life-affirming purposes.

Rob Bennett has recorded a podcast titled Money Magazine Is Asked: “Just How Bad Would Things Have to Get Before You Changed Your Advice?”. His bio is here.