Valuation-Informed Indexing #82: The Five Most Important Advances in Our Understanding of How Stock Investing Works

by Rob Bennett

We’ve learned more about how stock investing works in the past 30 years than we did in all the time before that. Not many people appreciate that. Not too many are jumping up and down today about how what we have learned has made stock investing safer and more financially rewarding.

That’s because we have not yet gotten serious about spreading the word about what we have learned. That’s a different matter. We’ve made amazing advances that will pay off for all of us once we all become comfortable with the idea of discussing them openly.

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stimulus dealCanyon Partners' Canyon Balanced Funds returned -0.91% in October, net of fees and expenses, bringing the year-to-date return to -13.01%. However, according to a copy of the firm's investor correspondence, which ValueWalk has been able to review, the fund quickly bounced back in November, adding 7.3% for the month. Net of fees, the letter reported, Read More

The breakthrough was Shiller’s finding that valuations affect long-term returns. That did away with the Efficient Market Theory (not in a practical sense, but in an intellectual sense). Five major advances followed from that.

1) Stock returns are predictable.

If valuations affect long-term returns, knowing the valuation level that applies at the time you purchase an index fund must tell you something about what the long-term return on that stock purchase will be. There can be healthy disagreements about the extent to which returns are predictable. But the question of whether returns are predictable or not has been settled.

Future energies will be directed to determining how predictable stock returns are and what strategies make best use of predictability.

2) Staying at the same stock allocation at all times is dangerous.

In the days when we thought that the market was efficient, Buy-and-Hold strategies (staying at the same stock allocation at all times) made all the sense in the world. If stock returns cannot be predicted, stocks are equally risky at all times. Thus, it makes sense for an investor to identify the stock allocation best suited to his risk tolerance and maintain it through his investing lifetime.

This logic does not apply in a world in which returns are predictable. In a world in which returns are predictable, the risk associated with stocks changes with changes in valuations (stocks are obviously more risky at times when likely returns are low than they are when likely returns are high). Investors should obviously be aiming to maintain the same risk profile at all times. So in a world in which returns are predictable, Buy-and-Hold is a dangerous and irresponsible strategy.

3) Risk Is Largely Optional

Risk is uncertainty. The idea that stocks are a risky asset class is rooted in the ideas about how stock investing works that were developed in pre-Shiller days, when we did not know that long-term returns are predictable. By learning how to predict returns, we make risk optional (not entirely, but to the extent returns are predictable). Those who do not find appeal in risky asset classes can now elect to invest in stocks only when there is little chance of obtaining a poor return and to avoid stocks when the odds of obtaining a poor return are high.

4) Bonds Are Not Necessarily the Best Counter to Stocks

The appeal of bonds is that they are a reasonably high-return asset class that carries less risk than stocks. In a world in which stock risk has been greatly diminished, the appeal of bonds is diminished too. At times when stocks are priced so that risk is minimal, stocks are the better choice. And, at times when stock risk is high, it makes more sense to invest in asset classes that offer guaranteed real returns (TIPS and IBonds) because the money invested in these asset classes can earn far higher returns in stocks than they could in bonds once stocks are again well-priced.

5) Economic crises can be avoided.

The boom/bust cycle has long been the bane of capitalism. Everyone of course loves the wealth generated during booms. But the financial devastation experienced during busts has left many skeptical of whether the booms are worth the price that is paid for them. Learning that stock returns are predictable provides us with an effective means for bringing the boom/bust cycle to an end. Once investors learn how to change their stock allocations so as to achieve the highest lifetime return possible, they will be selling stocks each time stock prices rise to dangerous levels and thereby pulling them back down to reasonable levels again. A boom cannot develop in such circumstances. And, without booms, there are no busts.

Rob Bennett has recorded a series of podcasts on how to invest wisely. His bio is here.