Valuation-Informed Indexing #238
by Rob Bennett
I have recently been engaged in e-mail correspondence with a fellow whom I met on the Quora.com site named “Alessandro.” We have been discussing the respective merits of Buy-and-Hold (the model for understanding how stock investing works rooted in the research of University of Chicago Economics Professor Eugene Fama) and Valuation-Informed Indexing (the model rooted in the research of Yale Economics Professor Robert Shiller). Alessandro is curious enough about the Valuation-Informed Indexing concept to want to ask lots of questions and learn more. But he remains highly skeptical. Set forth below are excerpts from our ongoing conversation (Alessandro’s comments are in italics):
I follow closely your answers on Quora and I appreciate your passion when explaining concepts to people. I’m new to investing and I’ve noticed that you are a strong supporter of using P/E10 as a predictor of stock returns. Why are you a strong supporter of P/E10 as a possible predictor of stock returns if it’s clearly much better to have a Buy-and-Hold strategy?
The question that I have put on the table with development of the Valuation-Informed Indexing concept is
whether Buy-and-Hold is as good as it is made out to be, whether higher returns can be obtained with less risk. The flaw in Buy-and-Hold is the assumption (the data DOES NOT support this assumption) that risk is constant.
If risk is constant (that is, if your chance of getting a good result is the same at all times), Buy-and-Hold is
the ideal strategy. The Buy-and-Hold strategy really does follow logically from he old belief that the market is efficient (that is, that all important information is quickly priced in).
The market does not behave like that. Stock prices do not fall into a random walk pattern. The P/E10 level starts at the sort of low you saw when you began your analysis at a P/E10 of 6. Valuations go steadily up (with small and short-lasting drops mixed in) until they hit 25 or higher. Then they collapse back to 7 or 8. Investors who are heavily in stocks when the collapses take place lose two-thirds of their money. Investors who to a large extent avoid those collapses have far more money to invest in stocks when prices are back to levels where the market can provide solid long-term returns. So those investors end up FAR ahead of the Buy-and-Holders in the long term.
I agree that, If we were able to avoid collapses, everyone would be much better off. The issue is that I have yet to find a predictive model for stock returns. P/E10 has some predictive capacity, but it apparently is not enough. The reason is because the stock market can yield great returns even at high price levels or generate lousy returns at low price levels.
This is so in the short-term but not in the long term. All bad long-term periods began at times of high P/E10 levels. All good long-term periods began at times of low P/E10 levels.
Think about a casino. Players can win in ten pulls of a slot machine. That happens all the time. But players never win at 10,000 pulls of a slot machine. It takes times for the odds to assert themselves. So it is with stock investing. People who buy stocks at high prices can come out ahead for five years or ten years or even fifteen years. But they never end up ahead at the end of an investing lifetime. The odds are so heavily against investors who ignore price when setting their allocations that they eventually catch up to them.
Fascinating theory. But I would be very cautious not to mix up correlation with causation. It seems you would like to change the investment world and the human psychology, while I’m only here to maximize my return.
Yes! This explains so much.
90 percent of investors don’t care about theory. They want to know how to maximize their returns and that’s all.
It was the Buy-and-Holders who came up with the idea of rooting one’s strategy in the peer-reviewed research. I loved this idea. I became a Buy-and-Holder myself because I loved this idea so much.
Then I learned about how the findings of the peer-reviewed research changed in 1981. What we thought was so from 1965 through 1981 turned out not to be so. Science is not unchanging. Our knowledge advances over time. We achieved a huge advance in 1981. I developed Valuation-Informed Indexing to reflect the advance (I incorporated all aspects of the Buy-and-Hold Model that were not discredited into the VII Model).
But Buy-and-Hold did not start failing people in a serious way in the practical realm until 2008 and even the price drop we saw in 2008 was not long-lasting. So most people are still okay with Buy-and-Hold.
I am HORRIFIED that the theory behind it has been discredited and yet people still use it. But that’s me. Most people don’t look at things that way.
Most people want to invest for the long term. But I don’t think that people today understand how far out the “long term” goes. Stocks behave very differently at one year out and at 10 years out and at 30 years out. People need to know the realities that apply for each of the various time frames.
My bottom line re all of this is that we are as a people at a primitive level of understanding of how stock investing works. In other circumstances, we would be eager to learn new things. But it is scary to accept that we don’t know all there is to know about how to invest our retirement money. So we pretend that we know more than we really do. And that gets us into trouble.
I believe that we are on the verge of achieving huge advances. But it is probably going to take another price crash for these ideas to be widely publicized. That obviously makes me sad. But I have come to believe that that is the reality that we all face today. The good news is 50 times more good than the bad news is bad. But the bad news is pretty darn bad all the same.
Rob Bennett recorded a podcast titled Stock Picking Works. His bio is here.
