by Rob Bennett
The idea that Buy-and-Hold Investing (sticking with the same stock allocation no matter how high valuations go) can work is counterintuitive. When we buy cameras and cars and clarinets and comic books, we look to price to determine whether the value proposition being offered is reasonable or not. Why wouldn’t that be so with stocks too?
It’s University of Chicago Economics Professor Eugene Fama who convinced the world (90 percent of it, anyway) that stocks are the exception that proves the rule, the one thing you can buy in this Consumer Wonderland of ours for which price need not be considered. Why? Because the market is “efficient.” Investors consider all relevant factors when setting the price, so there is no means by which any investor can through the use of intelligence beat the market.
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Yale Economics Professor Robert Shiller blew that theory up in 1981. He published research showing that valuations affect long-term returns. If valuations affect long-term returns, long-term returns are predictable for those willing to look at valuations before setting their allocations. Those who invest in such a way as to make returns predictable are obviously going to obtain higher risk-adjusted returns than those who do not. So the market can be beaten. With ease.
Shiller’s finding is the most important in the history of investment research. The only negative to stock investing is the risk. RIsk is uncertainty. To the extent that returns become predictable, risk is diminished. We have discovered the Fountain of Youth of investing: High returns combined with minimal risk. What could be better? How are we going to hold back the crowds anxious to make a speedy transition from Buy-and-Hold to Valuation-Informed Indexing?
There are no crowds! People hate Valuation-Informed Indexing. I am the concept’s leading promoter on the internet and it is more common for me to be greeted with bricks thrown in my direction than with welcoming committees. How come? What’s going on?
One big problem is that most promoters of Valuation-Informed Indexing take far too apologetic a tone when making the case. I point you to a comment Shiller makes in his book Irrational Exuberance that I think should strike anyone persuaded by Shiller’s case as polite to the point of excess, perhaps even outright odd.
On Page 171 of my copy, Shiller says: “The efficient markets theory and the random walk hypothesis have been subjected to many tests using data on stock markets, in studies published in scholarly journals of finance and economics. Although the theory has been statistically rejected many times in these publications, by some interpretations it may nevertheless be described as approximately true. The literature on the evidence for this theory is well-developed and includes work of the highest quality. Therefore, whether or not we ultimately agree with it, we must at least take the efficient market theory seriously.”
That’s too kind.
I mean it. That’s too, too, too, too kind. It’s so kind it’s dangerous.
We should be grateful to Fama for his many important contributions. I certainly agree with that much. I agree that there is a technical sense in which some of the claims made pursuant to the Efficient Market Theory might be described as ”approximately true.” But the bottom line is that Shiller’s research shows both the Efficient Market Theory and the Random Walk Hypothesis to be false. These ideas are in error. That’s important. That point needs to be made forcefully. These discredited ideas must be corrected.
If the ideas are bad ideas and yet people continue to invest pursuant to them we are going to see millions of people suffer failed retirements as a result. If the ideas are bad ideas and yet people continue to invest pursuant to them, we are going to see another massive stock crash. If the ideas are bad ideas and yet people continue to invest pursuant to them, we are going to see a worsening of the economic crisis and in all likelihood will within a few years be entering the Second Great Depression.
Having the ideas that millions of middle-class people use to invest their life savings being shown to be “approximately true” is not good enough. These ideas have some good aspects to them. We obviously should continue making use of the good aspects and showing the appropriate gratitude to those who put the ideas forward. Still, we must all evidence a greater sense of alarm than Shiller’s evidences in these words. If the ideas are in some hyper-technical sense “approximately true,” they are in a practical sense a whole big bunch more false than they are true.
We need to have Shiller saying that in clear and bold and firm and unmistakable words. We need to have other academics doing the same. We need to have all investing experts doing the same. We need to have economists doing the same. We need to have policymakers doing the same.
Investing ideas that are in some hyper-technical sense “approximately true” are just not good enough. We need to teach the millions of middle-class people suffering the human misery caused by Buy-and-Hold Investing the realities of stock investing as revealed by the academic research of the the past 30 years. We need to tell people not what is “approximately true” but what is actually and sincerely and verifiably and scientifically true. We need to stop deferring to those talking mumbo jumbo and begin engaging in serious efforts to get the word out about the good stuff that was developed to supplant the mumbo jumbo after the mumbo jumbo was discredited.
Valuation-Informed Indexing isn’t “approximately true.” It is just plain old true. If someone presents evidence that it is not true, then it will be false and I hope that all those who once advocated it will promptly acknowledge as much. To paraphrase the Bible, we need to hear experts in this field saying “yes, yes” or “no, no.” The lukewarm investing advice that our main man Shiller offers up in the passage quoted above we need to vomit out of our mouths.
The “approximately true” Efficient Market Theory has failed. Let’s move on to something better.
Rob Bennett challenges the conventional money management advice at his web site. His bio is here.