Valuation-Informed Indexing #281
by Rob Bennett
We have thus far only scratched the surface of the many powerful insights put forward in Robert Shiller’s amazing book Irrational Exuberance. Set forth below are seven claims made in the book followed by my arguments for why these claims should be explored in book-length examinations.
Claim #1: “The need for such a book is particularly urgent today, in view of the widespread and quite fundamental disagreement about the stock market. When people disagree at such a basic level, it is usually because they possess only pieces of the overall picture. Yet meaningful consensus can only be achieved by laying out all the available facts.” (from the Preface)
Shiller says that stock prices are determined primarily by investor emotions. It is because investor emotions are so powerful at times of high prices that we have not yet seen a national debate on the merits of his ideas. We are caught in a Catch 22. It is because investors are emotional that they cannot bear to hear why Buy-and-Hold doesn’t work and it is because we aren’t hearing why Buy-and-Hold doesn’t work that we remain so emotional.
Claim #2: “How we value the stock market now and in the future influences major economic and social policy decisions that affect not only investors but also society at large, even the world.” (from the Preface)
All who work in the investing field are compromised in their ability to point out dangers of the conventional wisdom re how markets work. Even if they don’t agree with the conventional wisdom, they need to maintain friendships with advisors and researchers and journalists who do. It is only people outside the field who can fully appreciate the significance of Shiller’s findings. But those people often doubt their own tentative beliefs because they view those who work in the field as possessing more expertise.
Claim #3: “Much of the evidence is drawn from the emerging field of behavioral finance, which, as the years go by, is looking less and less like a minor sub-field of finance and more and more like a central pillar of serious finance theory.” (from the Preface)
Buy-and-Hold has its roots in Adam Smith economics. The core premise is that investors are rational. Behavioral Finance questions this idea. If Shiller is right, we need to go back to the beginning and reformulate all of our ideas re how stock investing works. We didn’t get one or two things wrong. We got it all wrong.
Claim #4: “The outlook for the stock market into the next ten or twenty years is likely to be rather poor — and perhaps even dangerous.” (from the Preface)
Shiller is often credited for doing something that he did not do (predict the tech crash of 2000) and rarely credited for doing what he really did do (predict the bad economic times that were caused by the out-of-control stock market of the late 1990s and that will likely continue to frustrate the financial dreams of millions for years to come.
Claim #5: “Unknown to most investors is the troubling lack of credibility in the quality of the research being done on the stock market.” (from the Preface)
I gained my fame on the internet by being the person to discover the errors in the Old School safe-withdrawal-rate studies, studies that millions of investors used to plan their retirements. I was attacked by Buy-and-Holders who claimed that I did not possess sufficient expertise to question their studies. Today every major publication in the field has pointed out the problems with the once-widely-accepted “4 percent rule.” The poor research has remained uncorrected because prices have remained high and people have not experienced the consequences that follow from placing one’s confidence in poor research. But what happens when we see millions of failed retirements?
Claim #6: “The extension from Ponzi schemes to naturally occurring speculative bubbles appears so natural that one must conclude, if there is to be a debate about speculative bubbles, that the burden of proof is on skeptics to provide evidence as to why Ponzi-like speculative bubbles cannot occur.” (Page 67 of my edition)
When stock prices get out of control, the stock market becomes a respectable Ponzi scheme. Those are the worst kind because a large number of people who try hard to avoid the ordinary sort of Ponzi scheme can be taken in by the respectable kind.
Claim #7: “It is a serious mistake for public figures to acquiesce in the stock market valuations we have seen recently, to remain silent about the implications of such high valuations, and to leave all commentary to the market analysts…. The valuation of the stock market is an important national — indeed international — issue. All of our plans for the future, as individuals and as a society, hinge on our perceived wealth, and plans can be thrown into disarray if much of that wealth evaporates tomorrow.” (Page 204)
If millions of retirements fail, we will be facing the biggest social catastrophe in our nation’s history. We all need to know whether it is the Fama model (Buy-and-Hold) or the Shiller model (Valuation-Informed Indexing) that gets it right.
Rob Bennett’s bio is here.