Valuation-Informed Indexing #339
by Rob Bennett
The Delbrook Resource Opportunities Master Fund LP declined 4.2% in September, bringing the fund's year-to-date performance to 25.4%, according to a copy of the firm's September investor update, which ValueWalk has been able to review. Q3 2021 hedge fund letters, conferences and more The commodities-focused hedge fund has had a strong year of the back Read More
Shiller cites the 145 years of historical return data showing that valuations affect long-term returns as support for his claim that the market is not efficient because it is only if prices are largely determined by emotions rather than by reason that mispricing (irrationality) could continue to play so big a role for so long. Buy-and-Holders often respond to this evidence by noting that humans have an inclination to make sense of a chaotic world by identifying patterns that do not really possess significance.
Barry Ritholtz made the case (without applying it to the debate between Buy-and-Holders and Valuation-Informed Indexers) in an article he recently posted at Bloomberg.com titled The Philosophical Failings of Forecasting. Barry writes: “A wide range of prognosticators — consultants, economists, investment advisers and others — have turned the dark arts of foretelling the future into a lucrative profession. They have successfully developed the tools to separate those who badly want to know the unknowable from their money…. Philosophically, most people don’t like to admit the inherently random nature of life…. Believing in predictions allows people to overlook their own ignorance, discount the role of randomness and generally overestimate their own skills. If you think you (or someone you pay) can divine the future, you create the illusion of control and stability, where often there is none. Order is created out of chaos; it is a comforting illusion.”
I strongly endorse the point that Barry is making but I do not endorse the attempt by my Buy-and-Hold friends to put it forward as a justification for not exercising price discipline when buying stocks. I believe that in the valuations context, it is the Buy-and-Holders who are making a mistake by denying patterns that really do exist and that very much need to be recognized by investors hoping to achieve long-term investing success.
Barry is right that it is very hard to make effective forecasts in the investing realm. This is why I advocate indexing for those not willing to direct lots of energy and time to studying individual stocks. Stock picking is always rooted in some sort of forecast and, while I believe that those who possess an aptitude for this sort of thing can indeed profit handsomely from it, I also believe that the average person is probably better off taking a pass. It is just too easy to persuade yourself that you see something that few others see and then to get locked in to a purchase that ends up exacting a big financial price.
It is also why one of the core principles of Valuation-Informed Indexing is to disdain the temptation to predict where stock prices will be headed in six months or in a year or in two years. My Buy-and-Hold friends press me to make short-term predictions all the time. I am always reluctant because I don’t think that anyone can make such predictions. But there have been a few occasions on which I have agreed in the interests of fun and accountability to play the game. Guess what? My short-term predictions always fail. I cannot even seem to get them right on the percentage of occasions re which this should be possible just by pure chance. Barry is right. We like to tell ourselves that the world is a more predictable place than it really is.
The Buy-and-Holders would say that they avoid the problem of engaging in futile forecasting by avoiding expectations re how the market will perform in coming days. They just assume that stocks will continue to be an outstanding asset class and ignore the day-to-day noise of this guy predicting this and this gal predicting that.
I don’t think this approach to avoiding the mistake of vain forecasting works. One of the problems with us darn humans is that we can rationalize just about anything that we deep in our hearts want to do. Buy-and-Holders talk the anti-forecasting talk. But do they walk the anti-forecasting walk?
A fellow posting at the Bogleheads Forum once declared: “I would never walk into a bank and say ‘I want to invest $10,000 in certificates of deposit” without first checking what interest rate was being paid. Why would I want to do that when buying stocks?” This fellow’s point is that it is impossible for any of us to invest in anything without first forming some expectation of what return we will obtain from the investment. The Buy-and-Holders don’t really avoid forecasting. They just hide knowledge of their forecasts from themselves so they don’t have to face the irrationality of buying stocks at times when stocks are priced to provide a poor long-term value proposition.
In January 2000, the most likely 10-year annual return on stocks was a negative 1 percent real. Treasury Inflation-Protected Securities were paying a guaranteed return of 4 percent real at the time. That’s a difference of 5 percentage points of real return . Multiplied by the 10 years for which the differential applied, the Buy-and-Holders gave up 50 percent of their starting-point portfolio value by refusing to ask of stocks the question they would ask of certificates of deposit before putting money down on the table for them.
Why do Buy-and-Holders not identify the return being paid on stocks before buying them? Because they really do make forecasts but they are fantasy forecasts that they do not want to acknowledge even to themselves because they understand that these forecasts would sound silly if spoken aloud. Buy-and-Holders “forecast” that stocks will provide long-term returns at least somewhat close to the average long-term return of 6.5 percent real at all times.
There s no evidence supporting these forecasts. But they sound reasonable so long as they are not examined closely. The 6.5 percent figure really is the average return that has applied for many years, after all.
Forecast are indeed flawed. It’s an unfortunate reality that we all must make do with flawed forecasts when choosing the asset classes in which to invest. But the Buy-and-Holders make investing more risky than it needs to be by pretending to themselves that they are the only investors who avoid forecasting altogether. By doing so they close their eyes to the merit of using valuations to make much better flawed forecasts of future returns.
Rob’s bio is here.