by Rob Bennett
Yale Economics Professor Robert Shiller showed in research published in 1981 that valuations affect long-term returns. This means that the market cannot possibly be efficient in the way maintained by University of Chicago Economics Professor Eugene Fama and that the Buy-and-Hold Model for understanding how stock investing works — rooted in Fama’s vision of an efficient market — cannot work in the real world. If valuations affect long-term returns, the value proposition of stocks is a variable thing rather than a constant thing; thus, long-term investors must change their stock allocations in response to big price swings if they are to keep their risk levels roughly constant.
We have been living in denial of this reality for 30 years. Shiller’s insight puts us on the path to learning for the first time in history how stock investing really works. That’s exciting. But some news is so good that it is hard for the humans to let it in. This change is so big that it frightens us. Did we really get it so wrong before? Set forth below are descriptions of seven rationalizations for ignoring the Shiller insight that I have heard in my daily travels around the internet, followed by my explanation of why in my view they do not hold water.
Rationalization #1: Timing Doesn’t Work. Many investors are so convinced of the merit of this claim that they have come to believe that merely repeating the words one more time proves the case. No. The idea that timing might not work is actually an exceedingly counterintuitive one. If lowering one’s stock allocation when stock prices go to insanely dangerous levels does not permit investors to obtain higher returns at lower risk, stocks are the only asset on Planet Earth re which the price paid does not affect the value proposition obtained. The only reason why many smart people came for a time to believe that timing doesn’t work is that many once believed in the now-discredited Efficient Market Theory.
Rationalization #2: Many Experts Endorse Buy-and-Hold. There are also many experts who do not endorse Buy-and-Hold; if the case for Buy-and-Hold were as strong as most Buy-and-Holders suggest it is, there would be no disagreement. Moreover, even many Buy-and-Holders acknowledge that valuations affect long-term returns, a belief that is inconsistent with a belief that investors do not need to change their stock allocations in response to big price swings. Finally, many of the people widely identified as “experts” in this field are employed by firms that make huge amounts of money via stock commissions; such people can hardly be expected to offer non-biased assessments of whether it is a good idea for investors always to maintain a high stock allocation or not.
Rationalization #3: Valuations Do Affect Long-Term Returns But There Is No Way for Investors To Benefit From Knowing This Reality. I have spoken to many people who appear to me to hold a sincere belief in this one. I attribute this to cognitive dissonance. It seems to me to be a logical impossibility that investors would not gain an edge by investing more heavily in stocks at times when the long-term value proposition associated with doing so is strong than at times when the long-term value proposition associated with doing so is poor.
Rationalization #4: There Has Never Been a Time When Large Numbers of Investors Followed Valuation-Informed Strategies. This is an historical fact. But things change. It was once an historical fact that man could not fly and that anesthesia was not available to people in surgery and that many children died of whooping cough. The idea of making investing a subject of academic research only got into swing in the 1960s. So the only way Buy-and-Hold could have proven flawless would have been if we got everything 100 percent right on the first try. Taking a big-picture perspective, it hardly seems surprising that it took a few decades for us to formulate an investing model that actually does the job. We’re not even behind any reasonable schedule.
Rationalization #5: Even If We Taught Investors the Realities, They Are Too Emotional to Invest Effectively. Have we ever tried? How can we know until we try? There are lots of good signs. The fact that Buy-and-Hold has become so popular is in one sense an extremely encouraging sign; Buy-and-Hold was marketed as a safe and simple data-based strategy. What reason is there to believe that investors who in the past have taken with great enthusiasm to flawed data-based strategies will not be more than willing to follow a safe and simple data-based strategy that incorporates the findings of the last three decades of research?
Rationalization #6: We Don’t Know If Shiller’s Findings Will Stand the Test of Time. We don’t. But at least we can say of Shiller’s findings that they are consistent with what common sense tells us must be so. The price we pay for stocks should matter; it’s the idea that price doesn’t matter that is counterintuitive. If we are going to refrain from putting too much confidence in research, we logically require ourselves to hold off on committing too strongly to Buy-and-Hold. It certainly makes sense to conclude that Shiller may be wrong (Shiller says often that this is his own belief). However, it does not make sense to continue to promote the belief that Buy-and-Hold has been proven beyond a reasonable belief in the face of a substantial body of research pointing to a very different conclusion.
Rationalization #7: Buy-and-Hold Worked Well for a Long Time. The proper way of describing the reality of the 1980s and 1990s is that investing heavily in stocks worked well. Stocks were selling at extremely low prices in the late 1970s, when Buy-and-Hold became popular, and prices did not reach insanely dangerous levels until 1996. So there were only four years (1996 through 1999) in which Buy-and-Hold performed well despite dangerously high valuations. That’s a result entirely consistent with Shiller’s research (Shiller’s work does not provide any reason to believe that short-term price movements can be predicted by looking at valuations).
I’ll describe seven more rationalizations in next week’s column.