Valuation-Informed Indexing #234
by Rob Bennett
The shift from Buy-and-Hold (the model for understanding how stock investing works that is rooted in the research of Eugene Fama and that posits that stock investing risk is constant) to Valuation-Informed Indexing (the model for understanding how stock investing works that is rooted in the research of Robert Shiller and that posits that stock investing risk is variable, changing with changes in valuation levels) is a paradigm change; it is not one change but a set of changes with a total effect that is “revolutionary” (a word used in the subtitle to Shiller’s book). Last week’s column examined why paradigm change is hard.
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As hard as paradigm change is, we have no choice but to achieve it. If Shiller’s research is valid (there is now a mountain of evidence that it is), the continued promotion of Buy-and-Hold strategies is hurting us all in serious ways. The stock market becomes a car with no brakes when Buy-and-Hold strategies become popular, investors who fail to exercise price discipline (long-term timing) have no means by which to keep prices at reasonable levels. Set forth below is a list of six things we need to keep in mind to achieve this transition.
1) Our Knowledge of How Stock Investing Works Is Primitive. There really is no such thing as an investing expert today. If you compare claims made by different big names in this field, you will see that they are often in conflict. That means that at least one of the “experts” must be wrong! The even more shocking reality is that it is not uncommon to find a single expert making two claims that conflict with each other! It’s not that the experts are dumb. It’s that none of the currently popular theories for how stock investing works hold together.
The Buy-and-Holders thought that they had developed the first true reseach-based approach. But Shiller’s finding that valuations affect long-term returns casts doubt on the entire Buy-and-Hold Model. If today’s P/E10 level goes a long way to revealing the return we will see over the next 10 years (and it does), all investors need to practice long-term timing (changing your stock allocation in response to big shifts in valuations with the understanding that you may not see benefits for doing so for as long as 10 years) to keep their risk profiles constant. What? Timing works? That’s heresy for Buy-and-Holders!
They didn’t get it all right the first time. They need to return to the drawing board. By correcting their errors, the Buy-and-Holders will make the rest of their model workable in the real world. But it takes a certain humility for one to correct one’s errors. The Buy-and-Holders would find it easier to explore the new paradigm if they didn’t feel the pressure that comes with thinking that you must have all the answers. The reality is that we are ALL involved in a learning exercise. NONE of us have all the answers yet.
2) Those Who Challenge Our Thinking Are Our Friends. I once wrote a column at another site saying that John Bogle caused the economic crisis. The market was overpriced by $12 trillion in 2000. Shiller’s research shows that every dollar of overvaluation disappears from the market over the course of about 10 years. So Shiller predicted in his book that we would be seeing an economic crisis late in the first decade of the new Century as $12 trillion worth of spending power disappeared from our economy. It was the promotion of Buy-and-Hold strategies (which caused the insane level of overvaluation that did us in by telling investors that there was no need for them to lower their stock allocations as prices rose to insanely dangerous levels) that did us in. Several posters at the site got upset with me, arguing that I was being unfair to Bogle.
That certainly was not my intent! I love Bogle. I view all of my work as an extension of his work. Bogle has done more than any other human being alive to popularize indexing and, without indexing, Valuation-Informed Indexing obviously could not exist (long-term timing only works with index funds, not with individual stocks). Bogle made a terrible, terrible, terrible mistake. He also has blessed us all with scores of powerful and genuine insights.
It is Bogle’s friends who try to make him aware of mistakes they think he may have made. Bogle obviously wants to get it right. It is only when those of us who believe he has made mistakes bring them to his attention that he stands a chance of achieving the goals he set out to achieve when he was young. I have seen many Buy-and-Holders evidence a great deal of defensiveness when the implications of Shiller’s research are pointed out to them. We need to help them overcome this defensiveness if we all are to move forward to the development of far superior strategies.
3) Investing Is Not a Hard Science. Shiller once gave an interview in which he pointed out why the investing world has been slow to explore the implications of his research findings. Shiller’s findings are behavioral finance findings. P/E10 doesn’t just measure valuations, it measures human emotions (the Shiller model posits that it is investor emotions that determine stock prices, not economic developments). Shiller noted in his interview that there is a widespread feeling that the study of investor emotions is too “soft” and “fuzzy” for those concerned with the serious subject of how to finance one’s retirement.
Investor psychology is the Forbidden Continent of investing analysis. The subject is indeed a “soft” one in certain respects. But it is also a terribly important one. The reality is that none of the numerical calculations of which Buy-and-Holders are so enamored produce useful guidance unless calculations of how valuations (caused by investor emotion!) affect the results are taken into consideration. Investor emotions change prices dramatically and thus they influence all strategic choices dramatically. It is not possible to know the safe withdrawal rate without looking at the P/E10 level when the retirement begins. Nor is it possible to choose a stock allocation intelligently without looking at the P/E10 level that applies. Nor is it possible to assess the level of risk associated with stock investing without looking at the P/E10 level and how it causes risk to increase and diminish over time.
4) We Must Forgive Mistakes If We Are to Achieve Progress. No one who had once came to the conclusion that he knew it all ever learned anything in the following years. People in this field worry that lawsuits will be brought against them if they offer bad advice. That makes them anxious about admitting mistakes. And that hurts us all. Mistakes are learning experiences. We should be encouraging investing analysts to acknowledge mistakes by making clear to them that we will be forgiving of their mistakes.
And of course we need to be forgiving of our own mistakes too. We don’t know it all either. One of the reasons why the experts are reluctant to admit mistakes is that they are concerned about the reactions they will see from those who were taken in by the mistaken ideas and who suffered financial losses as a consequence.
5) We Must Celebrate Ambiguity. Fama’s ideas and Shiller’s idea cannot be squared. One of them is right and one of them is wrong. We cannot jump from believing in Fama’s ideas to believing in Shiller’s ideas in one day or one week or one month or even one year. There is going to have to be a time where we listen to both sides and compare the models to see which one best stands up to scrutiny. That means that there must be a time when we say “one school of academic thought says that your stock allocation should be 80 percent and another school of academic thought says that your stock allocation should be 20 percent.”
It sounds funny. A world in which people say that sort of thing will be a scary world for a time. But that sort of statement is part of the transition that we will have to travel through to move from the discredited investing model of the past to the highly promising investing model of the future.
Rob Bennett has recorded a podcast called I Was Wrong: The Bull Market Started in 1975, Not 1981. His bio is here.