Valuation-Informed Indexing #210
by Rob Bennett
Yale Economics Professor and Nobel Prize Winner Robert Shiller is my hero. He is the godfather of the Valuation-Informed Indexing model for understanding how stock investing works. I rate his book Irrational Exuberance as the most important book ever published in this field. It is my bible. I have reread it several times and have discovered important new insights that didn’t sink in to my brain on the earlier readings on each occasion. That’s the sign of a truly powerful work.
In April, Li Lu and Bruce Greenwald took part in a discussion at the 13th Annual Columbia China Business Conference. The value investor and professor discussed multiple topics, including the value investing philosophy and the qualities Li looks for when evaluating potential investments. Q3 2021 hedge fund letters, conferences and more How Value Investing Has Read More
There’s only one flaw to the book.
It doesn’t offer any concrete, practical help to the person seeking to learn how to invest his retirement money!
The primary reason why people buy investing books is to learn what to do with their money. Irrational Exuberance is amazing on theory. But Shiller devoted only two paragraphs of his masterwork to the how-to questions.
Here is what he says: “So what should investors do now? The natural first step may be, depending on current holdings and specific circumstances, to reduce holdings of U.S. stocks…. But there is a fundamental difficulty with advising individuals and institutions to get out of the stock market. If such advice were taken by large numbers, it would cause an immediate drop in the level of the market. In fact, we cannot all get out of the market. We can only sell our shares to someone else. Somebody must be left holding the outstanding shares. As a group, those unfortunate people who bought in at a market high have already made their mistake, and we cannot correct it for them after the fact.”
There is an interesting point being made here. But the overall argument being made is weak and not responsive to the point that most people buying investing books want to see addressed — What should I do with my money? It is not true, as Shiller suggests in the words above, that those who paid insanely high prices for the stocks they own have already made their mistake and are now doomed. Those who sell today obtain the price being offered today and are off the hook. It is true that investors who overpaid for stocks made a mistake by doing so. But until prices fall, they can cancel out the effect of that mistake entirely. In fact, those who did not purchase most of their shares at the highest price (this is most investors) make out well by selling so long as the price at which they sell is higher than the price at which they bought.
Shiller’s concern is that, for every investor who wins by selling, there is an investor who loses by buying. The suggestion is that investors collectively will not be better off if there are enough sales to bring stock prices back to fair value.
That’s not so. We are collectively better off when prices drop to fair-value levels. That’s always so. An overvalued stock market always hurts us all. Shiller of course shows that he understands this in all sections of his book that do not discuss the how-to questions. It is the essential point of his life’s work.
Shiller says that, if lots of investors do what is in their best interests (sell their shares while the high prices remain in effect), it will cause an immediate drop in price. That’s certainly so. That’s what we want to see happen! The only way that prices can be brought down is for lots of individuals to act in their self-interest and sell. How else could fair-value prices ever be restored?
My sense is that Shiller is concerned that a quick drop in prices would bring on a recession. But had we experienced a recession back in March 2000, when his book was published, we might well have recovered by that recession by now. So the economic crisis that we are enduring today would be history. Wouldn’t that be a good thing? The right way to think about it is not to view the individual investors as having already made their mistake but to view the society that is going to endure the economic collapse that inevitably follows a bull market as already having made its mistake. Each individual investor can avoid the downside of a bull market by selling before it brings on an economic collapse. But the society that tolerated the bull market cannot avoid the collapse. That’s unfortunate. But it is a reality that we need to face. And it sure seems preferable for us to swallow our medicine and get the recession behind us as quickly as possible rather than to stretch our the pain for many years or even for decades.
I don’t think it is an accident that Shiller held back from addressing the how-to questions in an entirely forthright manner. It is forthright statements along those lines that enrage investors following Buy-and-Hold strategies. People have their hopes and dreams tied up in their stock portfolios and it hurts for them to hear that they have made terrible mistakes.
We all need to work harder to offer clear statements to people who don’t want to hear them because they are hurting. We need to make a special effort in this regard while also appreciating how hard it is to go there and showing understanding to those who pull some punches as a means of avoiding having abusive reactions directed at them.
Rob Bennett has recorded a podcast titled The Five Stages of Investing Grief. His bio is here.