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Valuation-Informed Indexing #348
by Rob Bennett
Notes From Schwarzman, Sternlicht, Robert Smith, Mary Callahan Erdoes, Joseph Tsai And Much More From The 2020 Delivering Alpha Conference
The following are rough notes of Stephen Schwarzman, Steve Mnuchin, and Barry Sternlicht's interview from our coverage of the 2020 CNBC Institutional Investor Delivering Alpha Conference. We are posting much more over the next few hours stay tuned. Q2 2020 hedge fund letters, conferences and more One of the most influential investor conferences every year, Read More
I don’t believe that Buy-and-Hold works. I see it as a dangerous strategy. But it is a strategy that possesses great intuitive appeal. That is the secret of its popularity.
A group of my critics posts at my blog on an almost daily basis, trying to trip me up or harass me or whatever. One time one of them asked a question that really did give me pause. This fellow pointed out that I say that at a time when stocks are priced at two times fair value investors need to divide their portfolio value by two to know the true value of their portfolios. Then he asked whether I thought that he could receive the full amount of the stated value of his portfolio if he converted his stock shares to cash on that day.
The answer of course is that he could indeed obtain the full stated value of the shares. The mutual find company that would be engaging in the transaction is run by smart people. Why would those smart people be willing to turn over two times the real value of the portfolio in exchange for those shares? That doesn’t make sense.
Valuation-Informed Indexing doesn’t make sense. That’s why it hasn’t caught on. Buy-and-Hold makes sense. That’s why it is the dominant strategy.
What’s going on there is that the Valuation-Informed Indexing strategy takes into consideration a reality of investing that the Buy-and-Hold strategy does not. That reality is that all investors are humans and humans often do things that do not make sense. Humans are irrational. Humans are emotional. Fail to take that into consideration and you can come up with claims that make perfect sense but which do not reflect the realities. To make accurate claims about how the market works, we need to accept our own irrationality.
Robert Shiller has said that the reason why he became interested in researching the effect of stock valuations on future returns is that his wife is a psychologist and he would engage in conversations with her about all of the odd ways in which humans behave. As a naturally curious person, he wondered whether humans might behave in odd ways when buying stocks as well. And of course he discovered that they do.
Shiller has also said that it puzzles him that the efficient market theory is taken so seriously. He has pointed out that there is no evidence that the market is efficient, it seems to be something that large numbers of people believe on faith. I think we believe it because we feel that we must believe it. Our ability to plan our financial futures depends on our ability to know the true value of our stock holdings. It scares us to question whether the nominal values of our stock portfolios are accurate. Those numbers must be accurate! Humans must be rational! If we’re not…. Well, maybe it’s better just not to go there.
I obviously think that it’s better to go there. I have been amazed and frustrated o learn how much resistance there is to the idea of taking Shiller’s research seriously, to exploring the implications of his “revolutionary” (Shiller’s word) finding that valuations affect long-term returns. But I don’t view our slow acceptance of the new way of thinking about how stock investing works to be all bad news. I believe that what is going on is that our brains recognize how big the change is that we are being asked to process and we are holding back in fear of going there. This suggests that, when we do finally work up the courage to make the leap, we will be able to make some big advances in a short amount of time.
There will never come a time when the mutual fund that produces the portfolio statement reflecting the dollar value of a portfolio will refuse to cash in that portfolio for the full stated value. That obviously wouldn’t fly. So what will happen when Shiller’s ideas become more widely accepted?
The way in which the portfolio statements are written will be revamped. My guess is that the first change will be that the portfolio statements will be changed to contain an indication of the P/E10 value that applied at the time that the numbers were calculated and an indication of the valuation-adjusted portfolio value. That will be disconcerting at times when stocks are priced at two times fair value. Investors will be left to ponder what it means to see that their portfolios are temporarily priced at one dollar value but have a real value of only half of that dollar value.
As investors become aware of the distance between the nominal portfolio values and the valuation-adjusted portfolio values, they will sell a portion of their overpriced stocks, bringing prices down. In time, most of the distance between the stated portfolio values and the real portfolio values will be erased. Overvaluation disappears once the humans trying to kid themselves about the value of their portfolios become aware of it.
Investor self-deception is counter-intuitive. We should want to know the true value of our portfolios. It’s because we are flawed humans that we are drawn to engaging in the self-deception that permits bull markets to exist. But Shiller’s findings have brought an end to those days of self-destructive ignorance. He is forcing us to become aware of how we deceive ourselves and thus making it possible for us to do less of it and thereby to live better lives.
The world changes when we become aware of our own craziness. And it changes for the better. Because it is by becoming aware of our craziness that we become capable of doing something about it. Humans are naturally irrational. But we are capable of achieving greater levels of rationality. We awarded Shiller a Nobel prize because, while we have to a large extent ignored his insights for 36 years now, there is a part of us that yearns for the liberation that follows from taking his ideas seriously.
Shiller has pointed us to a counter-intuitive truth about ourselves that we have held back from recognizing for a time because it embarrasses us but that we will ultimately embrace because we are drawn to the idea of attaining greater self-knowledge and the better, safer investing returns that follow from it.
Rob’s bio is here.