Valuation-Informed Indexing #369
By Rob Bennett
I don’t think that Buy-and-Hold works. It is a strategy that was developed at a time when it was widely believed that the market is efficient. If the market is efficient, it would be the ideal strategy. But if stock investing risk varies at different valuation levels, as Robert Shiller showed in 1981, the idea of staying at the same stock allocation at all times is a terrible idea. Investors should be adjusting their stock allocations with changes in valuations with the aim of keeping their risk profile roughly constant over time.
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But the ineffectiveness of the strategy is not the worst of its drawbacks, in my assessment. If it were just a matter of whether investors should stick with the same stock allocation at all times or change their allocation in response to big valuation shifts, different reasonable people could line up on both sides of the question and enjoy good discussions about the pros and cons of the two approaches. The most troublesome aspect of Buy-and-Hold is the dogmatism that it encourages in investors who come to believe in the strategy.
Buy-and-Hold is more than a strategy. It is a model for understanding how stock investing works. The core idea is that the future performance of stocks cannot be known. Believing that takes all sorts of questions off the table. Investors who come to believe that of course make strategic decisions based on their beliefs. And each strategic decision taken increases the investor’s emotional attachment to the underlying belief. To question the belief in one circumstance would require questioning whether many prior strategic choices were well-founded or not. Buy-and-Hold is a self-reinforcing sets of beliefs about how the stock market works.
I often note how stocks have provided a return of only 2.25 percent real from January 2000 through December 2016. Those 17 years of poor returns have left millions of middle-class people with less money in their retirement accounts than they expected to have in them by this stage of their lives. The fact that most of us have much less money in our retirement accounts than we expected to have in them at this point in our lives means that we spend less on vacations and cars and eating out and hundreds of other things. So the entire economy suffers as the result of our long record of slow portfolio growth.
In ordinary circumstances, we would be hearing lots of complaints about the failure of Buy-and-Hold to deliver anything close to average stock returns for 17 years running. But rarely do investors blame the Buy-and-Hold strategy for the shortfall in their retirement accounts. We all had the option in 2000 of purchasing Treasury Inflation-Protected Securities (TIPS) that were offering a guaranteed return of 4 percent real for as long as 30 years out. Why don’t we complain about the experts who advised us to stick with our high stock allocations even though stocks were then priced so high that exceedingly poor long-term returns were a virtual certainty?
To give consideration to the idea that TIPS could have been identified at the time as offering the superior long-term value proposition open up too many disturbing questions.
If TIPS could have been identified at the time as offering the superior long-term value proposition, promising a much higher return at greatly diminished risk, why didn’t we see that at the time? Why didn’t we even consider moving a portion of our retirement money to TIPS?
Why didn’t the experts in the field advise us to do so? Why weren’t there articles all over the internet pointing out the amazing risk-free return being offered by TIPS at the time and the insane level of risk associated with owning stocks at the valuation level that applied at the time?
If going with a high stock allocation was not such a great idea in 2000, is it possible that it is not such a great idea today either? Once the human mind accepts that there is some valuation level at which stocks are not worth owning, it is impossible for it not to try to identify that valuation level. What will we find out if we permit our minds to travel a bit down that path of inquiry?
Will traveling down that path of inquiry compel us to appreciate how Shiller was able to foresee the economic crisis of 2008 in the words of a book published in March of 2000? Is there a connection between high stock valuations and the economic crises that always seem to follow in their wake? Could it be that all investors who cheered on the huge stock gains of the late 1990s played a role in bringing on the economic crises that caused such vast human misery a few years later?
We all want to know how stock investing works. Of course. Our success in stock investing determines whether we will be able to achieve our most important life goals or not. So we all very much want to know how stock investing works.
But for the same reason we want to know — because stock investing is so important a subject matter — we do not want to learn that we have been doing it wrong for a long time now. Humans find it painful to acknowledge mistakes and, the more important the subject matter re which the mistakes were made, the more painful the acknowledgment of the mistakes that were made. If it turns out that it is possible to predict future stock performance with a good degree of accuracy, that’s a major advance in human knowledge. But any major advance in human knowledge that has been ignored for decades is hard for the humans who ignored it to accept at long last.
Had Buy-and-Hold not come before Shiller’s “revolutionary” (his word) research findings of 1981, we would all be Valuation-Informed Indexers today. Why wouldn’t we be? Obtaining dramatically higher returns at dramatically reduced risk is a compelling value proposition.
The reality, however, is that Buy-and-Hold came first. And, once we began travelling down the Buy-and-Hold road, we began making choices that caused us to feel an emotional attachment to the strategy that informed them. Now that we have experienced 17 years of sub-par returns, it hurts to acknowledge that there has been another perfectly reasonable and perhaps superior option available to us for a long time now. The longer an investor follows a Buy-and-Hold strategy, the harder it becomes for him to ask the questions that he needs to ask for serious doubts about the strategy to establish themselves within his mind.
Rob’s bio is here.