Valuation-Informed Indexing #233
by Rob Bennett
Robert Shiller’s 1981 finding that valuations affect long-term returns changes everything. If that’s so, stock investing risk is variable, not constant. Returns are predictable. Stocks are worth buying only when they offer a strong long-term value proposition compared to the super-safe asset classes. The primary purpose of investing advice is to help investors develop the emotional strength to avoid falling into the rebalancing trap and instead to keep their risk profiles constant by adjusting their stock allocations in response to valuation shifts.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
It’s been 34 years. And perhaps 10 percent of the investing population has thus far made the switch from Buy-and-Hold to Valuation-Informed Indexing. What’s the hold-up?
The transition from the model based on Eugene Fama’s research to the model based on Shiller’s research represents a paradigm change. Paradigm changes are hard. Here are 12 reasons.
1) Paradigm change requires that people change their views on ten issues at one time. Some investors accept that valuations affect long-term returns. But the new paradigm does not make sense unless they also accept that stock returns are predictable. Some accept that returns are predictable but don’t see how the effect of valuations can be quantified. Some agree that the effect of valuations can be quantified but don’t see how mispricings can remain in place for 10 years or longer. There are reasonable responses to all the questions that people ask. But many lack the patience to hear them all out because the new model requires a rethinking of every investing question.
2) Paradigms Change Rarely. People are accustomed to hearing about small advances in all sorts of fields. They accept that knowledge grows over time. But they are suspicious of paradigm changes because they bring on such huge advances. Paradigm changes are perceived as too good to be true.
3) Those Who Have Built Careers Around the Old Paradigm Resist Movement to the New One. Turf battles can be brutal.
4) Investors Become Emotionally Attached to Strategies They Have Followed for Years. None of us enjoy saying the words “I was wrong.” Especially on money issues. Especially when we see that, had we made the switch sooner, we could have lived richer lives.
5) Big changes are scary changes. That’s so even when they are positive. Most of us prefer sticking with the devil we know to venturing into unfamiliar territory.
6) Paradigm Change Cannot Be Done in Stages. It’s an all-or-nothing proposition. I often compare what we are going through in the investing realm today to what we went through in the early days of the civil rights revolution. The idea that one race of people would not be treated equally under the law was always 100 percent inconsistent with out nation’s founding principles. So why was it so hard to get the civil rights revolution off the ground? Old ways of thinking were embedded in every aspect of our daily lives: where we sent our children to school; what sorts of opportunities we had in the workplace; how we socialized; where we ate; and on and on. Not one of those things could be changed without ALL of them being changed because the old ways of going about all of these activities were all rooted in the same old paradigm.
7) The Dangers of an Old Paradigm Are Masked by the Fact That It Has Survived a Long Time. Shiller’s research taught us new and wonderful things about how stock investing works. But those who are reluctant to incorporate his insights into their thinking are inclined to rationalize their hesitation on grounds that the old thinking cannot be so bad if we have managed to get by all these years without access to the new insights. New paradigms are accepted when the negatives associated with the old way of thinking become too compelling to ignore. Things often have to reach a pretty bad state before that happens. Sticking with an old paradigm often appears to be the safer choice.
8) It Is Difficult to Have Two Paradigms Compete in the Marketplace of Ideas. New ideas come along all the time and are adopted after some debate. But a new paradigm advances knowledge in so big a way as to make advocates of the old paradigm look bad for promoting ideas of considerably less merit. So the general rule is that the old paradigm remains in place until enough pressure for changes builds up to force a complete collapse of the old ideas.
9) Books and Other Resource Materials Promoting the Old Paradigm Far Outnumber Those Promoting the New Paradigm. So long as this remains so (and it remains so until the old paradigm has been replaced), the old paradigm possesses more “street cred.” In fact, advocates of the new paradigm can be criticized as not being endorsed by as many experts right up until the day that the new paradigm becomes the dominant one.
10) The Stronger the Case for the New Paradigm, the More Defensive Advocates of the Old Paradigm Become. A new paradigm cannot arise without a strong intellectual case being built for it. But intellectual insights alone do not rule the day in the short term. Intellectual merit can actually be a negative for a time because it inspires a stronger and more determined reaction among those who for non-intellectual reasons are not yet prepared to make the leap to the new way of thinking.
11) Humans Are By Nature More Social Than Intellectual in Nature. We are not objective processors of information bits. We are emotional creatures who want to be popular. Old paradigms on their way out are always favored by more people than new paradigms on the way in. Those who advocate new paradigms are perceived as trouble-makers.
12) The Process Issues Associated With the Shift to a New Paradigm Strike People as Overwhelming. The rise of a new paradigm requires the rewriting of textbooks and the re-formualtion of calculators and the rebuilding of careers. It’s all too much trouble!
Rob Bennett has recorded a podcast titled Reversion to the Mean: We Are in Danger of Losing Site of All That Bogle Got Right. His bio is here.