Valuation-Informed Indexing #334
by Rob Bennett
My last two columns examined a recently completed research paper titled Shiller’s CAPE: Market Timing and Risk. The first column expressed concern re the paper’s finding that never before in U.S. history have we seen today’s extremely high valuation levels apply for so long a time-period. The second column looked to the research paper’s finding that overvaluation is “sticky” and argued that this is because stock prices are set by shifts in investor emotions and investor emotions are sticky. Today’s column will explore the headline finding of the paper — that it generally does not pay for investors to engage in valuation-based market timing (Valuation-Informed Indexing).
I of course do not agree. A number of years back I co-authored (with Wade Pfau) research showing that investors who follow Valuation-Informed Indexing strategies profit handsomely by doing so; they can increase returns by enough to be able to retire many year sooner or they can reduce risk by close to 70 percent. The new researchers are obviously not faking the data. How could they look at the same question and come to such a wildly different conclusion?
Some people believe in God and some do not. If you ask a person who believes in God where we come from, he will say that God created us. If you produce compelling scientific proof that we evolved from a lower form of animal, you have him trapped, no? You have demonstrated that he is wrong in his fundamental belief and he will “convert” to non-belief. No?
It doesn’t work that way.
If a believer were 100 percent convinced in the merit of the case for evolution, he would in most cases remain a believer regardless. He would conclude that the beauty of evolution is yet one more demonstration of the awesome power of God.
And of course it works the same way coming from the other direction. Ask a non-believer to explain a miracle that convinces believers and he will dismiss it. Argue that there is scientific evidence that the miracle is real and he will respond that the evidence must have been faked — it is not possible for there to be scientific evidence for a miracle. Why? Miracles are defined as events that cannot be explained through natural means. God’s works are of course supernatural. Someone who believes that science explains everything that exists cannot believe in God because God’s works are by definition beyond the reach of scientific understanding.
That’s how it is with Buy-and-Hold and Valuation-Informed Indexing. Buy-and-Holders believe that the market is efficient. Not because this has been proven in some ultimate, objective sense. Market efficiency is assumed by Buy-and-Holders. Once market efficiency is assumed to exist, evidence of it is seen everywhere. So the longer that someone is a Buy-and-Holder, the greater becomes his conviction that he has this stock investing thing figured out. He sees more and more evidence of market efficiency all the time, just as someone who believes in God comes to see God’s hand in all sorts of phenomena and just as someone who does not believe in God comes to as time goes on see more and more evidence that God does not exist. What we believe affects what we see and then what we see causes us to believe with all the more conviction.
And of course it works that way with Valuation-Informed Indexers too. I got started on the journey that led to production of this column with a post that I put to a Motley Fool discussion board on the morning of May 13, 2002. I was a proud Buy-and-Holder at the time. I thought that the Buy-and-Holders might have made a mistake by failing to include valuation adjustments in their calculations of safe withdrawal rates for retirees but that’s as far as my doubts went. However, the intensely emotional negative reactions that I saw from many of my Buy-and-Hold friends caused me over the course of the next few months to question whether Buy-and-Hold was as scientific a project as it is advertised to be and as I had previously believed it to be. Once I abandoned Buy-and-Hold for Valuation-Informed Indexing, I found more and more evidence that valuations not only must be considered but are the most important factor that must be considered in just about any investing analysis. Now I am in so deep it is hard to imagine that I could ever return to the Buy-and-Hold camp (although I of course like to think that I have been able to keep my mind slightly open).
We humans do not generally search for evidence as to how the world works, find it, and then come to believe in what we learned. The more common pattern is that we come to believe in something for emotional reasons and then search for evidence to reinforce that belief. We do sometimes change our minds when presented with fresh evidence. But we do that only in unusual circumstances. Our usual choice is to stick with long-held viewpoints, especially re matters where it is important that we get it right (like how to invest our retirement money).
I could detail why the authors of the new study came to different conclusions than the ones reached by Wade Pfau and Rob Bennett a number of years back. There are a number of differences in how the two studies were done. But I have elected to pass on that task because I don’t believe that going through the exercise would convince anyone of the merit of the approach that Wade and I followed. If you believe that it is possible to profit from long-term market timing, you are going to believe that Wade and I set things up properly. If you do not believe this, you are going to believe that the authors of the new study set things up properly.
I am not giving up hope that we humans can learn important things about how stock investing works by examining the historical return data. I am happy that the authors of the new study did the work they did. Perhaps they are right about some things that I have gotten wrong and I will over time become able to open my mind to what they are saying. Perhaps it will work the other way around. The important thing is that they have gone to the trouble to make an intellectual case for the Buy-and-Hold position. That will help people on both sides of the debate come to a better understanding of the realities and in the long term will help us as a people to advance in our common understanding.
Neither side in this debate is going to prevail tomorrow or on the day after that or on the day after that. I believe, though, that we are over time going to find ways to talk about these matters in a less heated way and that those more fruitful talks will in time lead us to some very exciting places. We are working through a process. Our good friends Valentin Dimitrov of Rutgers Business School and Prem C. Jain of the McDonough School of Business at Georgetown University have added some clues that did not exist before they came on the scene. We should be grateful to them for the good work they have done.
Rob’s bio is here.