by Rob Bennett
The home page of my A Rich Life blog contains a section called “People Are Talking” at which I set forth 105 comments from both big-name experts and ordinary investors about the need to make the transition from the failed Buy-and-Hold model for understanding how stock investing works to Valuation-Informed Indexing, the investing model of the future. The comment that I put first is one that was made by Bret Arends, a personal finance columnist for the Wall Street Journal.
Arends said in a column titled “The Market Timing Myth” that: “For years, the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go…. It’s hooey…. They’re leaving out more than half the story…. Anyone who followed the numbers would have avoided the disaster of the 1970s or the past lost decade on Wall Street…. I wonder how many stayed fully invested because their brokers told them ‘you can’t time the market.’”
Those are wonderful words. Those words tell the story that people need to hear before we can reach a consensus on how to bring the economic crisis to a quick conclusion.
That said, there are two words in that quotation that reveal a serious misunderstanding on Arends’ part. It’s not my intent to register even a tiny criticism of him by making that observation. None of us can get it 100 percent right until we all give ourselves permission to engage in open and free and frank and bold discussions of the realities.
Shiller’s 1981 showing that valuations affect long-term returns is the most shocking discovery in the history of stock investing and it is going to take decades before we will be able to come to terms with the many earth-shaking implications of that discovery. My hope here is that showing how even someone as smart and well-informed as Arends could get it wrong will help others to understand how exciting are the opportunities that would become available to us if we were to make a collective decision to begin now trying to get it right.
The two words are the words “fully” and “invested.”
Arends is saying that investors should not be fully invested when stock prices rise to insanely dangerous levels. What he means, of course, is that investors should not be fully invested in stocks at such times. Why doesn’t he say that? Why does he use words that suggest that it is only when we are invested in stocks that we are invested at all?
That’s what the Buy-and-Hold Model encourages us to think.
Stocks have been a bad long-term bet for 16 years running. If you were to follow Arends’ suggestion that you go with a low stock allocation at times when stocks offer a poor long-term value proposition, you would have gone to a low stock allocation in 1996 and stayed with that low stock allocation through all the years since.
Investors have two choices. They can stay at the same stock allocation at all times (Buy-and-Hold) or they can adjust their stock allocation from time to time in response to big valuation shifts (Valuation-Informed Indexing). Most investors don’t have any problem understanding why the price you pay for stocks affects the long-term value proposition delivered. So Valuation-Informed Indexing is a natural.
Except for one thing.
Following Valuation-Informed Indexing precepts would have kept you at a low stock allocation for 16 years running. That sounds extreme. Most investors try to avoid extreme moves, for obvious reasons. So most investors experience a great deal of skepticism when the Valuation-Informed Indexing concept is explained to them.
To understand what is going on with the economy today, you need to understand what is going on with our understanding of how stock investing works. Shiller’s work challenges everything we thought we knew about how stock investing works. The extent of the change we need to make is signaled by those two words Arends uses in his column — “fully” and “invested.”
Arends does not believe that IBonds are really an investment. Or that Treasury Inflation-Protected Securities (TIPS) are really an investment. Or that certificates of deposit (CDs) are really an investment. He is saying that investors who moved their money from stocks to IBonds or TIPS or CDs for 16 years were not fully invested for those 16 years.
Stocks and corporate bonds are not the only two legitimate investment classes. Investors who put their money into IBonds because the data shows that the long-term return is likely to be superior to that delivered by stocks are fully invested. It’s the same with TIPS and with CDs. We should all be putting our money where we are likely to receive an acceptable return in exchange for taking on an acceptable amount of risk.
The pre=Shiller research does not say this. The pre-Shiller research says that stocks and corporate bonds are the only two real investment classes and that things like IBonds and TIPS and CDs only serve as holding places, places in which to temporarily keep money that will in a year or two be moved to one of the two real investment classes.
I have not had a penny invested in stocks or 16 years now. I have been fully invested the entire time.
I am not engaging in semantics.
How we talk about things governs how we think about those things. People who believe that only investors who have their money in stocks or corporate bonds are “invested” are going to have a hard time leaving their money in IBonds or TIPS or CDs for 16 years running. To make the change from Buy-and-Hold to Valuation-Informed Indexing, we are going to need to change the way we talk about investing. We are going to need to come to understand that all investors seeking to maximize return while minimizing risk are “fully invested,” regardless of which asset classes it is they need to invest in to realize those important investor goals.