Valuation-Informed Indexing #373
By Rob Bennett
I worry that I am insulting the intelligence of my Buy-and-Hold friends by making the point stated in the headline. It’s so obvious! It’s like saying “it’s logically inconsistent to stock up on your favorite type of socks when they go on sale but to also insist that they are worth buying even when selling at two or three times the price that usually applies.” If price matters, then price matters both when it is low and when it is high.
I feel a need to go ahead and make the case anyway because the reality is that I hear Buy-and-Holders advance the illogical claim all the time. When prices crashed in late 2008, the standard advice from Buy-and-Holders was that investors should not sell in panic but in fact should buy more stocks because stocks were finally available at sale prices. It wasn’t quite true that stocks were “on sale” at the time. The fair-value P/E10 level is 15 and the lowest P/E10 level we saw in the wake of the crash was 13. So this was a very modest sort of bargain. But it certainly is true that stocks offered a far better long-term value proposition when the P/E10 value was 13 than they did when the P/E10 value was 26. So the advice to buy more stocks considered by itself was good advice.
How many investors actually followed that advice? My guess is that it was a very small percentage of investors who bought more stocks in late 2008 and early 2009. There are two reasons why: (1) Most investors were already holding high stock allocations; and (2) most investors were worried about the big reduction in their portfolio value experienced as a result of the price crash.
To take advantage of price drops, investors need to be prepared for them. Investors prepare for the opportunities presented by price drops by lowering their stock allocations at times when prices are high. Investors who had been going with modest stock allocations prior to the crash were well-positioned to buy stocks on sale to get their stock allocations up to higher now-appropriate levels. And investors who had been going with modest stock allocations prior to the crash were not experiencing the fear that investors who had been going with high stock allocations were experiencing at the time. A 50 percent price crash causes a 40 percent loss of portfolio value for an investor with an 80 percent stock allocation but only a 20 percent loss of portfolio value for an investor with a 40 percent stock allocation.
What’s the story? Why are Buy-and-Holders not capable of thinking logically re these matters?
I think that the biggest cause of the problem is an unfortunate marketing reality: there’s generally more money to be made selling stocks than there is to be made selling the safe asset classes that investors should be buying into when stock prices rise to dangerous levels. Most of the people who are promoted as “experts” in this field are compromised by their need to push stocks for a living. In some cases, they appreciate the benefits that investors could reap by lowering their stock allocations but hesitate to give voice to them. In other cases, they themselves are taken in by the pro-stock commentary that becomes ubiquitous at times of high stock prices (it is an excess of pro-stock commentary that causes the high stock prices!) and cannot even appreciate the case for a lowering of stock allocations at such times.
The other issue is that our thinking about how stock investing works is illogical because it is unbalanced. Stocks generally offer a powerful value proposition. That 6.5 percent average long-term return is hard to beat. But once we come to own stocks, we become emotionally attached to the asset class and tune out messages telling us that there are exceptions to the general rule. Our brains still function enough to inform us that buying more stocks when prices drop makes all the sense in the world but our pro-stock bias causes us to ignore any thoughts telling us that it makes equal sense to sell some stocks when prices rise too high.
Can investors overcome the crazy way of thinking about stocks that causes them to buy more stocks when prices are low but not to buy fewer stocks when prices are high?
I think so. The trick is to get in the habit of taking price into consideration at the beginning of the stock-buying process. Investors who want to remain logical need to make a lifetime stock-buying plan before they become so emotionally invested in stocks that their bias interferes with their ability to think clearly.
The last 36 years of peer-reviewed research shows that investors who adjust their stock allocations in response to big price swings earn far higher long-term returns while taking on dramatically reduced risk than do Buy-and-Holders. All investors want higher returns at reduced risk. To get what they want, investors need to do their thinking about stocks before they own them and become biased about them. They need to think in advance about how they are going to respond to price changes before owning the asset class causes them to get so emotional about it that they are not able to accept the dictates of logic.
Rob’s bio is here.