Valuation-Informed Indexing #318

by Rob Bennett

Markets set prices. That’s what they do.

That’s pretty much it, isn’t it? Markets are price-setting mechanisms, nothing more and nothing less. It’s important.

So how has it come to be that millions of investors have come to believe that it is not necessary to exercise price discipline when buying stocks? The Buy-and-Holders say that it is not a good thing to engage in market timing. But, unless investors adjust their stock allocations to reflect the changing level of risk associated with holding stocks as valuations change, they are not exercising price discipline. That cannot be a good thing, can it?

[drizzle]I think it is a horrible thing that most investors fail to exercise price discipline when purchasing stocks and that most investing experts discourage them from doing so. It’s so strange. How could anyone come to believe that the exercise of price discipline could be a bad thing in one market when it is such a good thing in so many others?

We don’t think about our stocks in the way we think about all other products and services that we buy. We root for low prices when we are looking for a car to buy and when we are looking for a vacation to buy and when we are looking for a sandwich to buy. But when stock prices rise, we cheer! We like to see high prices attached to our purchases of stocks.

Huh?

The root problem is that we don’t think of investing as a form of spending. If we overpay for a car, it hurts to consider the money that has been wasted. But we don’t expect to see any good come from money we spend on stocks for decades to come. So we don’t pay attention to the money going out. We focus on the long-term result and delude ourselves into believing that the money going out doesn’t matter. Note to self: When money is being exchanged, the amount included in the transfer ALWAYS matters; anyone who suggests otherwise is either not thinking clearly or is getting a cut of the action.

When we buy stocks, we purchase an income stream. The amount we pay for the income stream makes a difference. Most of us over the course of a lifetime spend more on stocks than on sandwiches or cars or houses. The benefits of being frugal when buying sandwiches and cars and houses pale in comparison to the benefits of being frugal when buying stocks. We could all retire much earlier if we only practiced the same level of frugality when buying stocks that we practice with all the other purchases we make in our lives.

I recently had an experience with losing weight that helped me to understand better the reason why our thinking about how stock investing works is so messed up. I have been trying to lose weight my entire life. Usually only 10 pounds or 20 pounds. But still. It has been a lifelong struggle.

I was diagnosed with diabetes a year ago and I lost 70 pounds without trying. My doctor told me that I had lost enough weight and that I should knock it off as she was getting worried that I was losing too much. I told her that I had never tried to lose a pound. It just kept happening.

Obviously something was causing the weight loss. It wasn’t that I was trying to lose weight. I was trying to avoid sweets and carbs. And I was measuring my progress two times each day. I checked my blood sugar level in the morning and before dinner. If I ate a chocolate bar or pasta, my blood sugar level would skyrocket. For a year now, I have been obtaining daily reinforcement of carb-and-sugar-avoidance eating strategies.

I believe that it is the regular, quick feedback that changed my eating behavior. I have always had a sincere intent to avoid foods that make me fat. But you know how we humans do. We rationalize. We say “this one exception won’t make too much of a difference” or “I can do better tomorrow” or whatever. Someday never comes and the weight remains. But the blood glucose reader has been calling me out on my self-deceptions for one year now. If I want that darn machine to report good numbers, I have to avoid the sugar and the carbs. I can fool myself with my lies but I cannot fool that darn machine.

So it is with stock investing. Fail to exercise price discipline (that is, fail to adjust your stock allocation in response to big changes in valuations) and you will not see bad results for 10 years or perhaps even a bit longer. The feedback mechanism is too slow to influence human behavior in an effective way. Most of us practice Buy-and-Hold strategies for years before we pay a big price for it and then of course it is too late.

What if investing advisors discouraged self-destructive investing behaviors in the way that my blood glucose reader discourages me from eating foods that are not good for me? What if there were calculators at every investing site that told investors the true value of their portfolios when valuations are factored in? That would change everything. Investors would no longer be taken in by the happy talk of the Buy-and-Holders. They would stop rooting for price increases that had to be paid for by losses down the road and only get excited by the real ones supported by genuine economic growth (the ones that provide only a boring 6.5 percent real annual return).

We are naturally drawn to Get Rich Quick strategies. But we can overcome our inclination with help from experts who are familiar with what the last 35 years of peer-reviewed research says and concerned enough with our long-term financial health to set us straight when we fall back into bad habits.

Markets set prices. The reason why stock markets crash is that the investors who buy the stocks like to delude themselves into thinking that price increases are something to be cheered rather than something to be regretted. We need better feedback mechanisms to help us overcome our unfortunate inclination to believe that Buy-and-Hold strategies can work.

Rob’s bio is here. 

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