Valuation-Informed Indexing #94
by Rob Bennett
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Buy-and-Hold doesn’t work. It cannot work. We’ve known this for 30 years.
So why do so many of the “experts” in this field still push it so relentlessly?
The most common response to this question is that it is a money thing. Used-car dealers would tell us that there’s no need to look at the price of a car before making a purchase if they thought they could get away with it. Millions of middle-class people are not terribly well-informed about stock investing but need to invest anyway. The Stock-Selling Industry knows that it can get away with things that wouldn’t fly for used-car salesmen. So they go for it.
That’s part of it, I have no doubt. But I think the story here is more complicated. Money considerations influence the people pushing Buy-and-Hold. I don’t believe that they are the only factor. The full truth is that I have doubts whether money considerations are even the primary factor.
A comment recently put to a Guest Blog Entry I wrote for the Married (with Debt) blog stated the case well the case for believing that financial considerations are the driver. He said: “Money managers advocate Buy-and-Hold in part because it helps secure individual investors’ money in their mutual find accounts — where it’s subject to fees. Investors who sell when they think stocks are high or when they get scared reduce mutual fund holdings, which reduces fees, both in the short term and potentially in the long term if they never come back. In short, Buy-and-Hold will produce the highest average mutual fund balances over time, which translates to the highest mutual fund management fees.”
Here’s the problem.
The P/E10 level always drops to 7 or 8 (one-half of fair value) in the years following bull market tops. That’s a 65 percent price drop from where we are today. How many middle-class people are going to remain heavily invested in stocks following a 65 percent price drop, coming after the poor stock returns we have been seeing for the past 12 years? Bueller? Anyone?
Buy-and-Hold causes bull markets. Bull markets cause price crashes. Price crashes cause investors to flee the market. If all Wall Street cared about were the fees it earns, it would not want investors following Buy-and-Hold strategies.
The alternative to Buy-and-Hold is Valuation-Informed Indexing. Valuation-Informed Indexing encourages investors to sell stocks when prices get dangerously high. Those sales cause prices to return to fair-value levels. They thereby relieve the pressures that would otherwise cause price crashes. It is price crashes that drive investors out of stocks. Wall Street would collect more fees if it advocated Valuation-Informed Indexing.
The poster quoted above is not entirely off base. He is probably doing a good job of describing how Wall Street views the matter. Wall Street is filled with short-term thinkers. In the short-term, Buy-and-Hold increases fees by keeping investors in stocks. However, in the long-term it causes the price crashes that drive investors out of stocks.
One of our big problems today is that so many think of investing as a zero-sum game. If you think about it that way, having people move out of stocks for a time is a negative for those who make money when people are in stocks.
But investing is NOT a zero-sum game. We are all better off if the market functions properly and the market cannot function properly unless investors act in their own self-interest by selling stocks when the value proposition drops too low. When the market becomes dysfunctional, productivity is diminished. We all lose money. And volatility increases. Volatility and low returns push investors away from stocks and that hurts the profits of those who sell stocks.
Many on Wall Street believe that letting investors know about the dangers of Buy-and-Hold would reduce their profits. But they are misunderstanding the realities. Anything we can do to make the market function more effectively benefits both us investors and the people on Wall Street who profit (quite properly) from our love affair with stocks.
I sometimes blame Wall Street’s desire for profits for the relentless promotion of Buy-and-Hold. I do this because I really do believe this is a factor. But my full belief is that Wall Streeters would make bigger profits if they would give up their love for Buy-and-Hold and begin directing their multi-million-dollar marketing budgets to the promotion of Valuation-Informed Indexing.
The experts in this field often tell us to focus on the long-term. They need to listen to their own speeches!
Rob Bennett’s web site contains his article on restaurant tipping tips and how not to impress your date. His bio is here.