Valuation-Informed Indexing #374
By Rob Bennett
I was once a Buy-and-Holder and I have great respect for the people who constructed and promoted the Buy-and-Hold strategy. I gave it up because Buy-and-Holders do not take valuations into consideration when making allocation decsions and I am not able to square that with the 36 years of peer-reviewed research showing that valuations affect long-term returns. I often ponder why it is that my Buy-and-Hold friends are not troubled by the strategy’s failure to take valuations into consideration.
Philip Carret was an investor and founder of Pioneer Fund, one of the first mutual funds in the United States. Carret ran the mutual fund for 55 years, during which time an investment of $10,000 became $8 million. That suggests he achieved a compound annual return of nearly 13% for his investors. Q1 2021 hedge Read More
Do Buy-and-Holders really believe that the stock market is efficient?
In theory, that would be a good explanation of why they don’t take valuations into consideration. If the market were efficient, all developments having a bearing on price would be reflected in the price of stocks. If that were the case, stocks would always be priced properly or at least as close to properly as can be achieved by humans. In a world in which the market were efficient, both overvalued markets and undervalued markets would be logical impossibilities and it would of course be silly to adjust one’s stock allocation in response to price swings.
But my interactions with thousands of Buy-and-Holders tell me that that is not the real reason for the price indifference of followers of the popular strategy. In 15 years of discussing these matters on discussion boards and blogs, I have only run into two or three Buy-and-Holders who were interested in making an intellectual case that valuations don’t matter because the market is efficient. The vast majority of Buy-and-Holders acknowledge that both overvaluation and undervaluation are possible.
In fact, you will often hear Buy-and-Holders say that, given the level of overvaluation present in the market today, investors should be expecting lower-than-normal returns from stocks on a going-forward basis. It’s hard for me to square that belief with a belief that investors should stick with their usual stock allocations. If returns are going to be lower, stocks offer a less appealing long-term value proposition and it makes sense to invest a smaller portion of one’s assets in this asset class. But the Buy-and-Holders appear to be entirely sincere in believing both that returns are going to be lower than normal on a going-forward basis and that there is no call for them to lower their stock allocations.
What are they thinking?
The evidence that stock returns are unpredictable in the short term (time-periods of less than 10 years) is strong. My sense is that most investors do not worry about what is going to happen to their investment dollar in time-periods going more than 10 years out. Buy-and-Holders pride themselves on possessing a long-term focus. But by “long-term” they mean time-periods of more than one year or two years or three years into the future. They believe that, if valuations are not going to have an effect within one year or two years or three years, they are just not worth worrying about.
In fairness to this way of thinking, the research-based finding that stock returns are not at all predictable in one or two or three years but are highly predictable in 10 years and in 15 years and in 20 years is a highly counter-intuitive finding. It’s true. This is indeed what the research shows. And it is a finding with far-reaching, positive implications for those seeking to invest effectively for the long-term. But it is not a finding that clicks with most of us.
I don’t think it would be right to say that most Buy-and-Holders outright dismiss Shiller’s “revolutionary” (his word) findings. Most Buy-and-Holders respect Shiller and assume that he must have done important work to merit his Nobel prize. Most ignore it rather than reject it. When they are asked to ponder the question “Is market timing a good idea?”, the question that goes through their minds is “Is short-term market timing a good idea?” Long-term timing is a concept that just doesn’t compute for Buy-and-Holders.
Stock returns have been dramatically subpar for 18 years running now. But Buy-and-Holders are not unhappy with them. When they assess the merit of their strategy, they consider the time-period from 1982 (the beginning of the last bull cycle) through 1999 as well, years when Buy-and-Hold performed very well indeed. Over the last 35 years, Buy-and-Hold has been a good strategy. That’s what counts for most Buy-and-Holders.
The trouble is that stocks are today priced at two times fair value, and, if those who are happy with Buy-and-Hold today saw their portfolio value reduced by 50 percent, they would not be so happy any longer. It can take a long time for the downside of the Buy-and-Hold concept to evidence itself. I believe that the minds of many Buy-and-Holders will open to new ideas following the next price crash.
Presuming that the next price crash takes valuations to fair-value levels or lower and that they remain there for some time, that will be the first time since Shiller published his research showing that valuations affect long-term returns that investors will be able to consider its implications without the bias that comes from enjoying years of good stock returns. I believe that we will see the launching of a national debate on the meaning of Shiller’s research findings at that time.
Rob’s bio is here.