Valuation-Informed Indexing #295
by Rob Bennett
Michael Mauboussin: Here’s what active managers can do
Buy-and-Holders don’t believe in return predictions. They say that it is not possible to predict returns effectively. Their cardinal rule is that investors should never engage in market timing and so they object strongly when Valuation-Informed Indexers use return predictions to change their stock allocations. That’s market timing. It doesn’t work. It’s crazy. It’s a mistake.
They believe this stuff. They are sincere in their repulsion for market timing and for return predictions. But the Buy-and-Holders make return predictions themselves!
They don’t know it. They fool themselves into thinking that they are not making return predictions. But it’s not possible to buy stocks without first forming some idea in your mind as to what return you expect to obtain. The Buy-and-Hold idea that it is not a good idea to make return predictions is not only strategically flawed. It is a logical impossibility.
Say that you were thinking of buying a car and that for some odd reason you vowed not to consider price when doing so. Could you do it? You could physically do it. But you couldn’t do it with a clear mind. Human reason demands of us that we consider price when trading money for something that we want to obtain.
It works that way with stocks too. It’s not possible to buy stocks without the thought entering your head that you would like to obtain a return on your money that is greater than the return that you could obtain from buying less risky asset classes. And it’s not possible to go ahead with the purchase without some notion of what return you expect to obtain entering your thought process.
The Buy-and-Holders kid themselves about this. They need to believe that return predictions are not possible or they could not remain Buy-and-Holders (Buy-and-Holders who elect to become clear thinkers are transformed into Valuation-Informed Indexers!). But they are not able to keep themselves entirely in the dark. Common sense intrudes. That’s why Buy-and-Holders become uncomfortable when people like me write on the internet about the implications of the last 35 years of peer-reviewed research in this field.
Buy-and-Holders believe that they are going to obtain a return of 6.5 percent real on their stock investments. That’s the average return. So that’s their default. They compare the 6.5 percent return they expect to obtain from investing in stocks with whatever return they can obtain from less risky asset classes and elect stocks when the expected return from stocks is better. It always is. That’s why Buy-and-Holders invest most of the money that they do not expect to need within a few years in stocks.
Buy-and-Holders of course understand that they are not going to see that 6.5 percent return every year. There are some years in which stocks provide a return of 30 percent and there are some years in which stocks provide a return of a negative 30 percent. But a positive 6.5 percent is the norm. That’s what Buy-and-Holders expect. That’s what Buy-and-Holders predict.
Ask a Buy-and-Holder what he expects his stock return will be after the passage of 10 years. He will say that he expects something in the neighborhood of 6.5 percent. He doesn’t expect precisely that. Of course, Valuation-Informed Indexers don’t expect their predictions to apply precisely either. He view the predictions we make by looking at the valuation level that applies on the day we make our stock purchases as in-the-neighborhood numbers. That’s how Buy-and-Holders view their prediction that the usual 6.5 percent return will establish itself once again.
The reality, of course, is that there is a strong chance the 6.5 percent return will not re-establish itself. It’s reasonable to expect such a return for stocks purchased at fair-value prices. But stocks are frequently sold either at inflated prices or at deflated prices. When stocks are sold at wildly inflated prices or at wildly deflated prices, it is not likely that the 6.5 percent return will apply in 10 years. The likelihood is that a return a good bit lower than 6.5 percent will apply (for stocks purchased at wildly inflated prices) or that a return a good bit higher than 6.5 percent will apply (for stocks purchased at wildly deflated prices.
A poster at the Bogleheads Forum once stated this idea in compelling fashion: “I don’t go into a bank and say ‘I’d like to buy three certificates of deposit’ without first asking what rate of return applies — Why should it be different when I buy stocks?”
It shouldn’t be any different. We cannot know the return we will obtain from stocks with precision. But then we cannot know the return that we will obtain from certificates of deposit with precision either. The inflation rate is unknown at the time of purchase of certificates of deposit and the inflation rate affects the real return obtained. With certificates of deposit, we all do the best we can. We look up the nominal return and we form some reasonable expectation of what inflation rate might apply. We educate ourselves to the best of our ability. This is the step that Buy-and-Holders fail to take when they buy stocks.
Why? Buy-and-Holder want to know the return they will obtain from the certificates of deposit they purchase. Why don’t they want to know the return they will obtain from the stocks they purchase?
They want to believe in bull markets. They want to believe that the 6.5 percent average return is a floor that applies even when prices are insanely high but that returns that exceed the 6.5 average return are real and do not pull future returns down. They want to believe in a fantasy that makes it impossible for them to purchase stocks in as informed a manner as they purchase certificates of deposit.
Rob Bennett’s bio is here.