Valuation-Informed Indexing #337
by Rob Bennett
Rarely do I run into a Buy-and-Holder who doesn’t impress me with his or her intelligence. And yet I believe that Buy-and-Hold is a dangerous strategy and that the evidence that this is so is readily available. Common sense tells us that we should practice price discipline when buying stocks since we do this when buying every other good or service available for sale and there is now 35 years of peer-reviewed research confirming that what our common sense tells us must be so really is so. The obvious puzzle is — Why don’t the Buy-and-Holders see what I see?
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Mike Piper at the Oblivious Investor blog did a good job of answering this one in a recent blog entry. titled The Problem With Market Timing Research. Mike hasn’t converted me back to Buy-and-Hold (that would be some article!). But he has advanced what I would say is the best case for why so many smart people toe the Buy-and-Hold line to this day.
Mike explained that an instructor in a class on retirement planning that he recently took “was super enthusiastic about a recent piece of research that showed that, based on historical data, retirees’ ability to safely spend from their portfolios would be improved if they followed a set of rules in which they dramatically adjust their asset allocation each year based on current interest rates and price-to-earnings ratios.” Yes! That’s indeed what the 145 years of historical return data available to us today does indeed show. And it is a truly exciting discovery that is known by only a small number of today’s investors.
But Mike said that he feels qualms about following that sort of investing approach with his own money regardless of what the recent research shows. He notes that a strategy that works well historically cannot be tested in a large number of real-world simulations. Those planning retirements need to know whether their strategy will work well over a 30-year time-period (from age 65 to age 95). If you begin a test today, you won’t know for 30 years whether the strategy passes it or not and by then it will be too late for you to make use of what you learn from the test. And to adopt the new strategy you have to pass up the conventional strategy, accepting all the risks entailed in doing so. There are no do-overs in the retirement planning game.
These are good points. I wish that we had a lot more than 145 years of historical return data supporting the Valuation-Informed Indexing strategy. And I worry that investors may be persuaded by my arguments into abandoning Buy-and-Hold to their detriment. I truly believe that Buy-and-Hold is dangerous. But I have been known to get them wrong from time to time. Go by what I say and you might hurt yourself in a big way. The question of whether to go with a Buy-and-Hold strategy or a Valuation-Informed Indexing strategy is an either/or thing and getting this one wrong can subject you to a serious life setback.
So I encourage you to read Mike’s article and to give the points made in it serious thought.
And then to return to your enthusiastic pursuit of the exciting Valuation-Informed Indexing strategy, the investing strategy of the future!
It’s true that we don’t have enough years of historical return data to say with certainty that Valuation-Informed Indexing will work in the future. But Mike Piper and the other Buy-and-Holders never explain why Buy-and-Hold should be the default choice. The case for Buy-and-Hold suffers from the same lack of a sufficient number of years of historical return data to test.
Given that we don’t have enough years to completely prove the case for either strategy, the logical thing is to go with the one that meets the common-sense test. That’s Valuation-Informed Indexing. Price matters in every market that exists other than the stock market. So why assume that things work out in just the opposite way in only this one market?
Mike is right that an investor has to choose one or the other strategy without knowing for certain which is the right choice and then is stuck with the results he obtains with no hope of a do-over if he happens to guess wrong. Most people feel safer going with the more popular strategy. I do not.
I have to feel comfortable with the logic supporting a strategy to go with it. The history of the development of these ideas tells me that Valuation-Informed Indexing has the stronger logical case behind it (Buy-and-Hold became dominant only because index funds were not available in 1965 and thus there was no way to test at that time whether long-term timing works) and the behavior of the Buy-and-Holders over the past 14 years tells me that even those who follow the dominant strategy feel grave doubts over their choice, doubts that they cannot acknowledge to themselves because they are too scary for them to entertain. The fact that such discussions cause Buy-and-Holders to experience such pain tells me that the primary appeal of Buy-and-Hold is emotional, not intellectual.
I wish that more Buy-and-Hold advocates would go to the trouble to debate the merits of their positions as Mike Piper did in this article. An airing of the pros and cons helps us all to think these matters through. And kudos to the instructor of Mike’s retirement planning course. I share that teacher’s excitement that we are all on the threshold of coming to terms with a new way of thinking about how stock investing works that shows the potential to enhance our lives in a big way.
Rob’s bio is here.