The Stock Market Is Only As Smart As the Investors Who Comprise It

The Stock Market Is Only As Smart As the Investors Who Comprise It
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 Valuation-Informed Indexing #362 on the topic of buy and hold investing and the wisdom of the crowds

By Rob Bennett

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A Buy and Hold friend of mine recently posted the following words to the discussion thread for one of my blog entries: “You’re confusing high valuations (a fact, historically speaking) with overvaluations (a judgement that the market is wrong, in effect that you’re smarter than Wall Street).

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I like the comment because it concisely and clearly reveals the primary difference between Buy and Hold believers and Valuation-Informed Indexers. It is absolutely correct to say that I believe that the market is wrong. That’s the entire idea of Valuation-Informed Indexing. We can know when the market is getting things wrong and how off the mark the market is and we should put that knowledge to good use by adjusting our stock allocations accordingly.

My Buy and Hold friend dismisses out of hand the possibility that the market has gotten things wrong. His comment suggests that the market is comprised largely of Wall Street experts who possess more knowledge about the value of stocks than I possess. So I should just give up this effort to outsmart the market.

Lots of people would view my position as the more arrogant one. Who am I to think that I can outsmart the market?

I see it the other way around. The market is comprised of people and all people are capable of making mistakes. So it is obviously possible that the market as a whole could make mistakes. To say that the only case in which people can form together as a group and thereby become incapable of making mistakes is when they buy stocks is the truly arrogant claim.

Why do we think that stock market is collectively so smart?

I think it is because we find stock investing intimidating and presume that most people involved in it must know more than we do. That cannot be so on an overall basis. Smart people really do comprise a portion of the market. But so do dumb people and moderately intelligent people.

And of course it is not just I.Q. points that matter. Some people possess genius-level numbers of I.Q. points and yet do very dumb things. We run into these people all the time. They let their emotions get the better of them, regardless of their strong intellects. Why assume that stock investors are not subject to the same seemingly paradoxical behavior?

On top of all that, there are incentives for people engaged in stock buying to rationalize dumb behaviors. Consider the Wall Street types that my Buy-and-Hold friend suggests are the best-informed about the workings of the market. Fund managers who conclude through the use of their finely trained minds that stocks are so overpriced as not to be worth investing in are likely to lose their jobs if they cut back their stock allocations at a time when the less-informed people who own their funds think stocks are looking just great. To do the smart thing personally (retain their jobs), fund managers need to do the dumb thing professionally (ignore valuations).

The problem with Buy and Hold, in my view, is that it assumes that the market as a whole is smart enough to get things right. The way to make smart decisions is to assume as little as possible but to instead always remain on guard against mistakes of all types. When a large percentage of investors comes to believe that the market cannot get it wrong, that’s when the market lets down its guard and gets it horribly wrong. For so long as most investors worry about valuations, the valuation level for the market as a whole remains reasonable. When most investors become Buy and Hold types, there is no longer any intelligence working to keep prices in check and prices rise to insanely dangerous levels.

There’s a lot of intelligence being put to work by the community of stock investors, even at times when prices are high. Unfortunately, much of that intelligence is being employed to concoct rationalizations for why valuations don’t matter at times when prices are high. For our collective intelligence to be put to good use, we need to be sure to encourage those investors who have doubts about current-day prices to express those doubts. You don’t see that in bull markets. In bull markets, those who have doubts learn to keep them to themselves for fear of bringing on themselves the wrath of the many investors aspiring to ignore any doubts. It is by crushing the intellectual energy of the minority that bull markets rise to great heights. Bull markets are an anti-intellectual phenomenon.

My Buy and Hold friend did not deny that stock prices are high today. His objection is to my belief that the high prices are not justified. We could look at the historical return data to determine who is right. If we found that high prices always lead to poor returns in future years, that would prove that the market really is getting something wrong when it sets prices at high levels. I believe in doing that. I like to quantify the effect of high prices, to see just how bad future returns can be expected to get when prices rise as high as they have risen at a particular point in time at which the assessment is being made. My friend thinks I am wrong to do that. He thinks that I should defer to the market’s judgment over where prices should be.

It is my view that my Buy and Hold friend is telling me to turn off my brain. And that the result we produce when lots of us turn off our brains is a market less smart than it has the potential to be. I believe that the market is in the process of becoming smarter than it has ever been in the past. I believe that, as we continue to explore the far-reaching implications of Shiller’s “revolutionary” (his word) research findings of 1981, the market will become smarter and smarter until at some wonderful day in the future it will really be almost as smart as the Buy and Hold investors have always assumed it to be.

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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