Valuation-Informed Indexing #342
by Rob Bennett
The study of human psychology is a relatively new discipline. It is my belief that the biggest mistake made in the early years of development of the new discipline was the focus that was placed on curing neuroses. Yes, we need to cure neuroses. But what many people need is a model of healthy, positive human psychological interactions. A lot of us get it wrong because we have never been taught how to get it right.
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Valuation-Informed Indexing is the model for understanding how stock investing works that acknowledges that investing is done by humans and that therefore human psychology must be considered by those seeking to give good investing advice. The same problem that has held back the study of human psychology in general has held back advances in the field of Behavioral Economics. We spend too much time and effort telling people how to avoid pitfalls identified by the study of human psychology and too little telling them the positives — how investors following healthy impulses proceed with the business of investing on a day by day basis.
There’s one phrase that encapsulates the problem, in my assessment. Fear and greed. We tell investors that there are times when the market is too consumed with fear — bear markets — and that there are times when the market is too consumed with greed — bull markets. It is the only case I know of where a psychological insight has penetrated the consciousness of just about all investors; everyone has heard the phrase “fear and greed.”
But the popularity of the phrase is a frustrating reality. There’s a good bit of truth in it. The market really is controlled by fear at times when prices are insanely low and by greed when prices are insanely high. Bu what is the policy prescription? What do we tell investors to DO to avoid the power of these two negative emotions?
Most investors exposed to discussions in which the phrase is used come away with one of two ideas. One is that there is nothing that can be done. Markets have been ruled by fear and greed since the first day and they always will be and so there is no point in fretting about it much. To say that the market is ruled by fear and greed is to say that sometimes it rains and you need an umbrella and sometimes it snows and you need boots. The idea here is that the phrase “fear and greed” merely describes reality; it’s not worth putting much effort into the project of determining whether this is a good reality or a bad one or what it is that as an individual you can do about it.
To think of things that way is to waste a grand opportunity. There was a day when smallpox killed millions. Good people determined to do something about it and then got about the business of actually doing so. This is how we should approach the fear-and-greed matter. Investors hurt themselves when they give in to temptations to let fear and greed influence their investment decision-making process. We should want to help them stop doing that. And there are important things that we can do. Being governed by fear and greed is not an eternal reality. It is a problem that needs to be addressed as quickly as possible and then left behind.
The other trap that we have fallen into is the Buy-and-Hold solution to the fear-and-greed problem. Buy-and-Holders possess a sincere desire to avoid the emotional traps of investing. But they lack confidence in their ability to overcome the pull of fear in bear markets and the pull of greed in bull markets. They vow to stick to the same stock allocation at all times, thereby insuring that emotions will not sway them either to over -nvest in stocks or to under-invest in them.
It might work if the world of investors was comprised only of Buy-and-Holders. But of course it is not. We all have responsibilities as investors to make the rational choices that render the market as a whole more rational and thereby less emotional. Buy-and-Holders opt out of this responsibility by choosing a one-size-fits-all stock allocation that fails to supply the corrective power needed to keep stock prices from getting too far out of hand in either direction. Buy-and-Holders tell themselves that they their stable stock allocations show that they don’t experience the emotions of fear and greed but in reality all that they show is that Buy-and-Holders are happy to be just as emotionally off the wall as the market is at any given moment in time. It’s not a mark of sobriety to run through the same red lights as a drunk driver on the justification that to do otherwise would be to suggest that you know something about traffic laws that no human can ever know.
There is an alternative to fear and greed. It is calm confidence. It is something that we all should be trying to achieve as investors. It is something that we all should be helping our fellow investors to achieve. We should be doing so without apology or hesitation.
When the market is being run by greed, prices rise so high that stocks are no longer worth buying in the same quantities. Those of us who see the dangers of investor emotionalism should stop buying stocks in the same quantities at such times. That would bring prices down. Behaving responsibly would cancel out the greed.
And of course it would work just the opposite way with fear. Buying more stocks when price drop too low would cancel out the fear.
Valuation-Informed Indexers don’t care whether price rise or fall. Price increases are good news in the short term and bad news in the long term while price drops are bad news in the short term and good news in the long term. Valuation-Informed Indexers are price indifferent. They possess a calm confidence about stock investing because their buying decisions are rooted in the research-based realities and so they don’t ever see their emotional balloons popped.
Rob’s bio is here.