Valuation-Informed Indexing #240
by Rob Bennett
Lots of investors don’t think much of my claim that investors need to change their stock allocations in response to big valuation shifts to keep their risk profiles constant over time and thereby to achieve good long-term investing results. I try to listen to and learn from even my harshest critics. My aim in this column is to list some important things I have learned from them.
For much of the past decade, Crispin Odey has been waiting for inflation to rear its ugly head. The fund manager has been positioned to take advantage of rising prices in his flagship hedge fund, the Odey European Fund, and has been trying to warn his investors about the risks of inflation through his annual Read More
Lesson #1: Buy-and-Hold Investors Truly Believe in Their Strategy. We all see things from different perspectives. I personally find it hard to accept that there are any investors who truly believe in the Buy-and-Hold concept. I consider price in every purchase I make and so the idea of not considering price when buying stocks is foreign to my way of thinking. Because my fundamental beliefs are so contrary to those of the Buy-and-Holders, I sometimes cannot help but doubt their sincerity. But I know from interacting with my critics that there really are millions of good and smart people who believe in Buy-and-Hold. That probably seems like an obvious point to most reading these words. For me, however, it is not intuitively obvious. I am grateful to my critics for making clear to me that there really is another way of thinking about these issues and that it is a way of thinking that possesses great appeal to many.
Lesson #2: One Aim That Buy-and-Holders Seek to Serve by Ignoring Valuations Is To Keep Things Simple. I am a big believer in the merits of simplicity. A theoretically pure and perfect strategy that is too complicated for the average investor to implement effectively will not produce good results. I learned from one recent discussion at my blog that one reason why Buy-and-Holders don’t advise allocation changes is that they worry that such changes will complicate the investing project for ordinary investors. I don’t think that’s so. I think that the anxiety that investors who fail to adjust their stock allocations experience during price crashes complicates their ability to stick to their plans. But I am persuaded that it was in part a desire to avoid complexity that caused Buy-and-Holders to push the valuations issue to one side in the early days of development of the strategy. My take is that a well-intended desire to achieve simplicity turned into something more dangerous when valuations rose to levels never anticipated in those long-ago days.
Lesson #3: Few Investors Follow Buy-and-Hold In a Theoretically Pure Way. Buy-and-Hold is rooted in the idea that the market is efficient and that thus risk is static and there is no need for investors to change their allocations in response to valuation shifts. My critics react in a strongly negative way to the idea that they should be going with different stock allocations at different times. But they are quite willing to acknowledge that few investors follow the Buy-and-Hold theory in a strict way. Most employ stock allocations lower than those that are identified as “optimal” in the Buy-and-Hold literature. The suggestion implicit in this argument is that I focus too much on theory. I don’t think that is so. I think theory is important. But I think my critics describe the psychological realities accurately. Theory may be important but most investors do not concern themselves much with theory. They cite theoretical claims only when they support their own choices, which they made without reliance on theoretical claims.
Lesson #4: It Causes Buy-and-Hold Investors Pain to Consider the Possibility That Their Strategy Is Flawed. My critics often direct personal attacks at me. I don’t like that, for obvious reasons. But years of interactions with Buy-and-Holders have taught me that I hurt them too even though it is not my intent to do so. If scientists had two theories as to how to cure cancer, they would explore them both at the same time until it became clear which possessed greater merit. That’s the way I wish it could work in the investing realm. The problem in the investing realm is that we all serve as laboratory rats in the experimentation needed to show which school of thought is correct. We cannot test either Buy-and-Hold or Valuation-Informed Indexing except by investing our own retirement money pursuant to one or the other of the two strategies. Those who bet wrong will suffer devastating consequences.
Lesson #5: The Stock Market Is Different From All Other Markets in Several Important Ways. One of the lines of questioning that comes up again and again in my interactions with Buy-and-Holders relates to how markets really work. It shouldn’t be possible for stock market prices to get so out of hand. Investors should want to exploit inefficiencies in pricing and thereby bring them to an end. One of the most interesting questions that all in this field should be exploring today (in my assessment) is why this doesn’t happen. I have come to believe as a result of my interactions with my Buy-and-Hold friends/critics that a big part of the problem is that stock investors think of themselves as owners of stocks even at times when they are purchasing more shares than they are selling. In the car market, the dealer is pushing for a high price and the potential customer is pushing for a low price. It is the conflict between the two sets of interests that produces the magic that permits the market to get the price roughly right. In the stock market, we all root for high prices. That’s why the market often becomes dysfunctional and does an exceedingly poor job of getting the price right.
Rob Bennett recorded a podcast titled What Should You Be Investing In When You Aren’t Investing in Stocks? His bio is here.