Valuation-Informed Indexing #214
by Rob Bennett
The book The Myth of the Rational Market does a fine job of explaining the history of explaining how we got to the strangeTwilight Zone period of understanding how the stock market works that we live in today. It explains how the idea that the market is efficient was disproven but then stops short of saying what that signifies for those seeking to invest effectively.
If the market is not efficient, we all must be sure to adjust our stock allocations in response to big price swings so that we can keep our risk profiles roughly constant. The book doesn’t reach that conclusion, It explains why the old ideas on how stock investing works have been discredited. But it then cops out on the matter of describing new ideas. It suggests that, even though all the reasons for believing that Buy-and-Hold strategies might work have been disproven, it still might be a good idea to follow such strategies.
I find zero merit in this line of thought. I am often tempted to conclude that the people pushing it do not believe themselves in what they are saying. But I must say in all fairness that all signs are that the DO believe. Many smart and good people sincerely believe that Buy-and-Hold strategies make sense even though the theory supporting these strategies was shot down three decades ago. As amazing and as scary as that reality is, that’s the reality of where things stand today.
The foundational idea supporting this line of thought is summed up in simple statement of principle. Ask people who follow this line of thought why they do and they will tell you that Shiller proved that valuations affect long-term returns and thus we must acknowledge that the market is not efficient and that investors are not rational. But it does not follow that return predictions work, according to advocates of this line of thinking (a line of thinking which might be categorized as the viewpoint halfway between the viewpoints held by Buy-and-Holders and Valuation-Informed Indexing).
Valuations affect long-term returns. But it is not possible to predict returns effectively. Huh? How can that be? What are people getting at when they say this???One possibility is that they are making the trite observation that short-term predictions still don’t work even though we now know that valuations affect long-term returns. That is certainly so. But it seems like such a silly thing to say that I hate to suggest that that is the message being conveyed here. I do not think that that is all there is to it.
The obvious way to go once you know that short-term predictions do not work and that valuations affect long-term returns is to make long-term predictions. If valuations affect long-term results, the riskiness of owning stocks increases with increases in valuation levels. So the investor hoping to keep his risk profile roughly stable MUST engage in long-term timing. That’s not much of an intellectual leap, is it? Surely everyone who has devoted a little bit of thought to the matter sees that.
Everyone sees it. But only on one level of consciousness. The people who say that Buy-and-Hold might make sense even in a world in which valuations affect long-term returns are smart people. They get it that long-term timing is the obvious way to go. They also see that some very far-reaching implications follow from that and that causes them to experience a great deal of anxiety. They don’t want to take big leaps forward. So they permit a learning block to kick in to stop them from seeing the otherwise obvious implication of their conclusion that valuations really do affect long-term returns and the market is not efficient and investors do not set stock prices through a rational process.
What is the nature of the fear? That is what we should be trying to figure out.
The nature of the fear is that stock investing becomes too darn easy a game once it becomes possible to engage in long-term timing. Stock investing no longer holds much risk to investors who know how to engage in long-term timing. That’s us! It’s a wonderful thing. But it can be a scary thing to see all your dreams come true.
Say that you spent ten years of your life working to get a dream job and today you have been told that you will start next Monday You are thrilled. But there is a part of you that is frightened finally to be living the dream. There is a part of you that wants to go back to questing after the dream rather than living it. You have never lived in this wonderful new world before. You are not entirely sure if it will turn out as you always imagined. There is a part of you that wants to wait a bit longer before turning to a new chapter of the book.
That’s where we are today in our understanding of how stock investing works. Of course long-term timing works. Of course it has always worked. Of course it always will work. Once we do away with the efficient market concept, there’s no reason to think otherwise. It was the efficient market concept that put doubts in our heads for a time.
We have suffered a lot of unnecessary pain. The Buy-and-Hold “idea” (that it is not necessary for investors to lower their stock allocations when valuations rise to insanely dangerous levels) has caused four economic crises over the past 140 years. If only we had known 140 years ago what we know now. To fully acknowledge that we know today things that those earlier investors did not know makes us feel unworthy. It almost seems unkind to take advantage of insights that those earlier generations of investors did not have available to them.
We’ll get over it. The next crash is going to hurt. That hurt is going to melt a lot of hearts. The people who today resist going forward are going to see the need to do so when they come to understand how much pain they have been causing us all by failing to help us move into the future.
Valuations affect long-term returns. That means that long-term timing works. That means that stocks are a much less risky asset class than we have long them them to be.
That’s the way it is. No ifs or ands or buts. Don’t let anyone tell you different.
Those who cannot say it yet are working through their fears about being the luckiest generation of investors who ever walked Planet Earth. Try to understand where they are coming from. But try to help them develop the confidence they need to move forward while doing it.