Valuation-Informed Indexing #154
by Rob Bennett
Yale University Economics Professor Robert Shiller showed with research published in 1981 that valuations affect long-term returns. The implications are huge. To the extent that knowing today’s valuation level tells you what your long-term return will be, stocks are no longer a risky asset class. You would intuitively be drawn to the conclusion that this research finding would have been explored from hundreds of different angles during the following 32 years.
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You would be wrong to reach that conclusion. Most of today’s investing experts act as if the Shiller research did not exist. Most advocate Buy-and-Hold strategies. Most express confidence that it is just fine to stay at the same stock allocation at all times. Why?
One, 32 years is not really that long a time-period in the grand scheme of things. We are accustomed to experiencing rapid change in many fields of human endeavor. Try to sell a computer that was popular 32 years ago today and you will not get far. So in one sense 32 years really is a long time.
The difference is that the idea that the market is efficient (and that, thus, Buy-and-Hold strategies can work) is rooted in economic theories that go back a long, long way. The idea that the market is efficient is rooted in a belief in the Rational Man economic assumption. That one goes back to the days of Adam Smith!
The historical reality is that economists have been losing confidence in the Rational Man concept for a long time. Eugene Fama expanded use of the concept to the investing realm just about at the time when it was running out of intellectual steam in any event.
In days to come, the expansion of the concept to the investing realm will be seen as the last nail in its coffin. The Rational Man concept could do only so much harm for so long as it was merely an idea employed by economists. Now it is an idea that is causing massive destruction to millions of middle-class investment portfolios. It’s going to be hard for us to ignore the obvious and well-documented flaws in the idea once it brings on the Second Great Depression.
Still, when you consider that this idea has been influencing economic thought for several centuries, it does not seem so shocking that it has been possible for influential people to turn their eyes from the flaws in the investing strategies rooted in it for three decades now.
Two, Shiller’s ideas have not been entirely ignored.
I’ve spoken to lots of economics professors about this matter. It still shocks me when I hear one of them say something to the effect of: “I stopped believing in Buy-and-Hold years and years ago! That’s old news! The point you are making is silly! No serious person believes in Buy-and-Hold today!
What do you say to that?
Buy-and-Hold is pushed ruthlessly and relentlessly at hundreds of web sites and newspapers. If “everyone” knows that it doesn’t work, why is that the case?
The marriage of academic research and marketing efforts in the investing realm has been a rocky one. One the one hand, people trying to sell stocks love to be able to say that a strategy that calls for always being heavily invested in stocks is backed by academic research. Lots of middle-class people worry about investing too heavily in stocks. It helps the sales pitch a great deal to be able to reassure them that there is research showing that they are doing the right thing.
On the other hand, reporting on the research that shows that Buy-and-Hold doesn’t work undercuts the marketing message in a very serious way. It’s that body of research that gets deep-sixed by most of the “experts” in this field.
The professors who tell me that they have known for many years that Buy-and-Hold cannot work are shooting straight. Those who follow the research closely really do know that. But there are few regular investors who know this. The popular web sites rarely mention it.
We essentially have two realities in place today. Among those who focus on theory, Buy-and-Hold is an idea that was laid to its rest decades ago. Among those whose livelihood depends on persuading people to go with large stock allocations, Buy-and-Hold is alive and well and wonderful stuff.
Three, the biggest bull market in history just happened to begin at the time when Shiller’s research was published. In the years immediately following announcement of Shiller’s revolutionary findings, it was perfectly natural that most people would remain skeptical. His findings stood our long-established understanding of how stock investing works on its head. You don’t want to buy into a change like that too quickly. It made sense to wait and see whether Shiller’s findings stood up to scrutiny.
After the passage of 32 years, I think it would be fair to say that the ideas have stood up to scrutiny. But the trillions and trillions of dollars of funny money produced by the huge bull left lots of people less than super-interested in learning about a new way to invest in stocks. The old way was working jut fine!
It’s only since the 2008 crash that the idea of examining the flaws of Buy-and-Hold has begun to gain a bit of traction. An out-of-control bull market covers a multitude of research errors. Had Shiller published his research in 1971 rather than in 1981, my guess is that Valuation-Informed Indexing would have become dominant by 1974 and that the name of the famous book would have been A Valuation-Informed Walk Down Wall Street.
Four, the advance in our understanding achieved by Shiller and those who have followed in his footsteps is huge. Huge changes are hard to digest. The good news here is that, when we do finally get down to the business of incorporating Shiller’s insights into our thinking re how stock investing works, we are going to make a lot of progress in a short amount of time.
Rob Bennett has recorded a podcast titled “The Efficient Market Theory Is a Big Bunch of Hooey.” His bio is here.