Valuation-Informed Indexing #97
by Rob Bennett
Michael Mauboussin: Here’s what active managers can do
The debate over active versus passive management continues as trends show the ongoing shift from active into passive funds. Q2 2020 hedge fund letters, conferences and more At the Morningstar Investment Conference, Michael Mauboussin of Counterpoint Global argued that the rise of index funds has made it more difficult to be an active manager. Drawing Read More
People want there to be a middle ground between Buy-and-Hold and Valuation-Informed Indexing.
Just about everybody acknowledges that valuations matter and that the idea of staying at the same stock allocation at all times thus makes no sense. But most people hate the idea of acknowledging that Buy-and-Hold was a mistake. My sense is that there is a feeling of shame that so many of us were taken in and that so much money was directed to promotion of this investing strategy. People want to move on but they want to move on in a modest way.
It can’t be done.
If Buy-and-Hold works, the idea of changing your stock allocation in response to big price swings is dangerous nonsense. If Valuation-Informed Indexing works, the idea of not changing your stock allocation in response to big price swings is dangerous nonsense. This is an on/off switch. If the market is efficient, Buy-and-Hold is the ideal strategy. If valuations affect long-term returns, Buy-and-Hold is the purest and most dangerous Get RIch Quick scheme ever concocted by the human mind (although not intended to be such, to be sure.)
There ultimately is no middle ground. But I don’t think it would hurt our efforts to promote Valuation-Informed Indexing to do all we can to create a feeling that we are meeting the Buy-and-Holders halfway. We cannot compromise on principle. If we do, our investing strategies will work no better than Buy-and-Hold strategies. But we can acknowledge the great good that the Buy-and-Holders have done and thereby apply a balm to hurt feelings.
1) Acknowledge that Short-Term Timing Doesn’t Work.
The Buy-and-Holders view it as their greatest accomplishment that they convinced millions that market timing doesn’t work. They were wrong. Long-term timing always works and is in fact required for those seeking to have a realistic hope of long-term investing success. Still, it really was a huge advance for us to discover that short-term timing doesn’t work. The Buy-and-Holders can be legitimately praised for putting forward this insight and should be.
2) Stress the Importance of the Introduction of Indexing.
There would be no Valuation-Informed Indexing had John Bogle not introduced index funds in 1976. Buy-and-Hold and indexing are not the same thing. But, because Bogle championed both, they are often perceived as being related concepts. Bogle wasn’t intending to facilitate long-term timing when he promoted the indexing concept. But the reality is that we couldn’t have gotten to where we are today without his efforts. Bogle revolutionized middle-class investing with his promotion of the index fund and we should do all we can to acknowledge the debt we owe him.
3) Highlight the Similarities Between Buy-and-Hold and Valuation-Informed Indexing.
The two models are very different. It fairly could be said that they are opposite models in that Buy-and-Hold makes investing a highly emotional enterprise (by trying to ignore the effect of valuations/emotions) while Valuation-Informed Indexing takes most of the emotion out of the investing project by requiring consideration of the effect of valuations/emotions when investing choices are made. But there are lots of similarities too. Both strategies are research-based strategies. Both strategies are aimed at long-term investors. Both strategies aim to serve as “good enough” strategies rather than to deliver the best possible returns. Both strategies are simple enough to be employed by the most casual of investors. There’s a lot of common ground.
4) Note That the Mistake Made by the Buy-and-Holders Was Understandable.
There is no reason to believe that the mistake made by the Buy-and-Holders was deliberate. In fact, it was a perfectly understandable mistake. Buy-and-Hold was developed in the late 1960s and early 1970s. Shiller did not publish his research showing that valuations affect long-term returns until 1981. How were the Buy-and-Holders supposed to know about the results of research that had not yet been completed? All mistakes seem obvious in retrospect. Lots of good and smart people believed in Buy-and-Hold in its early days.
5) Point Out that Shiller’s Findings Are So Far-Reaching That It Has Taken Decades for Their Significance To Be Fully Acknowledged.
In a perfect world, we all would have recognized the importance of Shiller’s findings in 1981 and adopted Valuation-Informed Indexing strategies in 1982. If Shiller’s insights represented a modest advance, I am confident that that is what we indeed would have done. The reality is that Shiller’s research turned everything we thought we knew about stock investing upside down. It will be decades before all the implications of his work have been revealed to us. The Buy-and-Holders cannot be blamed too much for being slow on the uptake. We all were.
We have to move on. There can be no middle ground. But it is only right to acknowledge that the Buy-and-Holders built the foundation on which we are building a new investing model today. The more credit we give the Buy-and-Holders for their genuine contributions, the quicker we will see them give up their defensiveness and join us on the path to development of an investing strategy permitting far higher returns to investors taking on greatly diminished risks.
Rob Bennett has written about stock picking for indexers. His bio is here.