Valuation-Informed Indexing #325

by Rob Bennett

Stock prices crashed in September 2008. Most investors reacted in one of two ways. Some panicked. Some didn’t. That’s the binary choice that follows from the conventional way of thinking about how stock investing works.

Both reactions make sense under the Buy-and-Hold Model.

If investors are rational and price changes result from unforeseen economic developments, there’s no cause for panic in response to a price crash. A price crash is certainly bad news according to this way of thinking because it shows that the economy is not in as good shape as was earlier believed. But the damage has already been done and an economic recovery is every bit as likely as a deepening of the downturn. So sticking with the same stock allocation that made sense before the crash still makes sense. Most Buy-and-Holders disdain panic in the face of a price crash.

There are exceptions. however. I visited the Bogleheads Forum frequently in the days following the 2008 crash (I was banned from the forum in early 2007 but I continued to read it to try to come to a fuller understanding of the mindset of the Buy-and-Holders). A good percentage of the board community was in a near-panic state in those days. This group did not comprise the majority of the board community but it represented a significant minority. And the members of this group were not in full panic. They were asking questions and expressing concerns suggesting that they would be entering panic mode if stock prices continued their march downward for much longer. When prices moved sharply back up again, the panicky thinking quickly diminished.

I do not view this second reaction, the panicky reaction, as being illogical. I certainly do not view panic as a good choice. But I can see how believing in a Buy-and-Hold strategy would lead an investor to experience panicky feelings in the wake of a price crash. Consider what a price crash represents in the mind of a Buy-and-Holder. Buy-and-Holders believe that price changes result from unforeseen economic developments. For prices to fall as hard as they did in late 2008 tells a Buy-and-Holder that the economy is in very bad shape indeed. That’s unsettling. I can see why someone would at least be tempted to panic in response to learning suddenly that an entire economy is collapsing for perfectly good reasons.

This is one reason why I view Valuation-Informed Indexing as a more emotionally healthy strategy. Valuation-Informed Indexers obviously feel distress over economic collapses as well. But we believe that it is the irrationality of investors that causes the collapses; the market must eventually pull prices back to fair-value levels and the loss of buying power that results from big price drops causes consumers to spend less and thereby causes businesses to fail. To a Valuation-Informed Indexer, an economic collapse is a bad thing achieving a good purpose — it is by crashing our economy that we pop the bubbles caused by the promotion of Buy-and-Hold strategies and thereby restore the health of a market that needs to function well for the economic system to continue to thrive.

We don’t like economic collapses. But we understand the need for them and we appreciate the role they play in setting the nation up for future growth and we certainly are not surprised by them. So they do not inspire feelings of panic in us.

Buy-and-Holders do experience feelings of panic in the midst of price crashes. The theory they advocate tells them that such feelings are inappropriate. But the price crash and the economic collapse that accompanies it are tangible and pressing realties; the Buy-and-Hold slogans don’t offer much comfort to the investor seeing his portfolio value dropping rapidly and hearing his concerns confirmed by his friends and neighbors and by news sources. Buy-and-Holders are human. They panic in times of crises. That’s what we humans do.

Why then do some Buy-and-Holders not panic even during crashes? The majority of the Bogleheads Forum was steadfast in its refusal to panic in late 2008 and early 2009. Why does the argument that panic is inappropriate work for some and not for others?

I have my doubts as to whether there are any Buy-and-Holders who are immune to panic. It is certainly true that most did not panic in 2009. But the 2008 crash was short-lived. I believe that all Buy-and-Holders would have eventually panicked had prices continued falling or even if the low prices that came to apply in early 2009 remained in place for several years. The refusal to panic worked because the test to which it was put was not a strong one. Eventually this secular bear market will produce a crash long-lived enough to break even those most adamant in their insistence that they cannot be broken.

How do I know? I look at the record of historical returns. There has never been a bull market that did not end in tears. The P/E10 value always falls to one-half of fair value by the end of the bear market that follows it. The P/E10 value cannot fall that low until nearly every investor gives up hope that prices will ever return to their highs. Irrational depression is as much a mainstay of the market as irrational exuberance. We couldn’t have extreme highs without the latter and we couldn’t have extreme lows without the former.

Buy-and-Holders think of themselves as immune to panic. The reality is that Buy-and-Hold causes panics. The more Buy-and-Holders deny the emotional realities of stock investing, the harder prices fall when they ultimately do fall and the harder the spirits of the investors experiencing the pain that goes with those falls ultimately drop as well.

Rob’s bio is here.