Valuation-Informed Indexing #237
by Rob Bennett
Bill James coined the term “sabermetrics” in 1980. The sabermetrics concept — the term is defined as “the search for objective knowledge about baseball” — revolutionized the sport.
I remember reading early editions of James’ Baseball Abstract. It was like entering a different world. For decades, we identified the best players by their batting averages. James said “no.” The batting average tells you how often a player gets a hit. But what matters is whether the player gets on base. A player who hits .280 and walks in 10 out of 100 at-bats (for an on-base percentage of .380) is better than one who hits .300 and walks in 2 out of 100 at-bats (for an on-base percentage of .320). It is a painfully obvious point. But one that most of the millions of smart people who follow baseball did not comprehend until James started publishing the Baseball Abstract and then Bill Beane adopted the “Moneyball” concepts that permitted the Oakland A’s to become competitive team on a tiny budget and then all of the other teams came to invest millions to improve their drafting and trading and lineup-setting decisions.
Yale Economics Professor Robert Shiller started a revolution in the investing realm at about the same time. In earlier days we thought that stock investing risk was a constant. It was believed that there was no need for an investor to change his stock allocation in response to price changes; in fact, it might well be a bad idea to do so. Shiller showed that stock investing risk is variable; the P/E10 level that applies when a stock purchase is made reveals whether that investment choice will prove to be a good one or a bad one in the long term.
The revolution started by Shiller is every bit as big a deal as the revolution started by James and popularized by Beane. But it has not had nearly the same impact. Most investing analysts recommend Buy-and-Hold strategies (strategies in which the investor keeps his stock allocation constant) to this day.
Why? Why did the one revolution “take” and the other have so little influence during the 35 years since both statistical-related revolutions got off the ground?
There are four reasons.
The primary reason is that it takes so long for Valuation-Informed Indexing (the investing strategy rooted in Shiller’s 1981 research findings) to produce good results. We learned that Buy-and-Hold is a poor strategy in 1981. But try telling that to those making use of Buy-and-Hold strategies! Buy-and-Hold produced amazing results for the next 19 years. The results had nothing to do with the theoretical merit of the Buy-and-Hold concept. Stocks performed well from 1981 through 1999 because stocks were priced insanely low in 1981. Stocks always perform well for many years when they are priced as low as they were in 1981. Still, the reality remains that stocks put up very good numbers. That convinced the investors following the strategy that Buy-and-Hold works.
It was a different story with sabermetrics. Bill Beane really did come close to losing his job when he played the role of trailblazer for the sabermetrics concept. But once his team began winning more games than it could be reasonably expected to win given the player salaries that were being paid, the general managers of other teams took notice and the new way of thinking about how to assemble a baseball team was tried in new places. There was resistance to the new idea just as there is resistance to Valuation-Informed Indexing. But strategies for assembling baseball teams either bear good fruit or bad fruit in the course of one year. Unfortunately, valuation-informed investing strategies can take 30 years or even a bit longer to demonstrate their power.
The second reason, paradoxically enough, is that baseball is just a game while investing is a serious matter. Intuitively, you would think that investing analysts would be quicker to embrace change because the price for putting forward poor investing advice is to cause your clients to suffer failed retirements. The reality is that the importance of getting it right in investing makes those who give advice reluctant to try new ideas. Change is always suspect until the new ideas have been proven right beyond any reasonable doubt. The old ways appears to be the safe ways. So investment advisors have been slow to embrace the far-reaching implications of Shiller’s revolutionary findings.
The third reason is that investment advisors must consider how their clients and readers feel about the new ideas. All that baseball fans care about is whether their team gets in the playoffs or not; they don’t care to see how the sausage is made. To persuade investors that they should be taking valuations into consideration when setting their stock allocations is to tell them that the numbers on their portfolio statements are not real, that they too need to be adjusted downward at times of high prices. Most investors are already worried that they will not have enough money to retire on when they get old. Experts who tell them that they are further behind in their retirement-finacing efforts than they realize are not popular experts. Unpopular experts often need to look for a new line of work.
The fourth reason is that there are 30 baseball teams competing with each other to win the World Series. The best way for a new idea to advance is for it to be tested extensively. Every baseball team has an incentive to test sabermetrics. If it works (it does), it gives them an edge.
It doesn’t work that way in the world of investing. Investing is a stressful idea to lots of people. The last thing that many investors want to hear is that there are two schools of thought as to the best way to invest for the long term and that Buy-and-Hold either works fine or is the worst possible strategy, we just are not yet entirely sure which it is. There is a perceived need in this field for most of the experts to stick with the same story. That has meant that for the 34 years since Shiller published his breakthrough research Valuation-Informed Indexing has rarely received the attention it merits.
The investing revolution will happen just as the baseball one already has. I believe that we will see change happen quickly following the next price crash. Change that in other circumstances would have played out over several decades may well be achieved in only a year or two of time.