Valuation-Informed Indexing #375 on stock investors and the role of rationality in determining prices
By Rob Bennett
There’s a reason why Freud had such a big reputation. When he explored phenomena like projection, he opened new fields of human inquiry. Pre-Freud, many people thought of humans as rational animals, beings who used their intellects to pursue advancement of their self-interest. Freud showed that we are self-deceivers. We believe ourselves to be pursuing our self-interest at all times. But often the reality is that we behave in irrational and counter-productive ways without being aware that we are doing so. It’s not just that life presents obstacles that are difficult to overcome. We create our own obstacles. We hurt ourselves.
So it is with stock investors. The word “irrational” is even in the title of Robert Shiller’s grounds-breaking book Irrational Exuberance. As a society we are not yet comfortable with Shiller’s findings and teachings. We patronize him. We tell ourselves that he had some interesting things to say about valuations but pretend that Shiller’s work is not all that big a deal.
The reality (in my assessment!) is that Shiller’s work is in the process of changing our fundamental beliefs about how stock investing works. The Shiller Revolution is the Freudian Revolution applied to stock investing. Buy-and-Hold is rooted in a belief that there is such a thing as a Rational Man and that he is the one who directs our decisions about stock investing.
Shiller showed that we are fooling ourselves when we tell ourselves that we are easily capable of rational stock-buying behavior, that we are able to act in our self-interest rather than giving in to the primitive emotional urge to push stock prices up to insanely dangerous levels once again and thereby make this asset class so much more risky than it needs to be.
Did Freud really make a difference? Some would argue that he did not. We still deceive ourselves today, we still hurt ourselves today, we study projection and all the other self-defeating behaviors that he brought to our attention. But it is always those who are most inclined to self-delusion who are least aware that they are engaging in it. Have we humans become more rational creatures over time? Has our study of human psychology helped us to behave better?
I like to think that we are capable of more rational, less self-destructive behavior today. And I like to think that that is where we are headed in the stock investing realm now that we have 36 years of peer-reviewed research showing us that valuations affect long-term returns and that the market is not a tiny bit efficient or rational.
You could argue that we are going backwards. The highest P/E10 level achieved during the current bull/bear cycle is the 44 we saw in January 2000. That’s a lot more dangerous than the previous high, the 33 we saw in the month before the Great Crash of 1929 and the Great Depression that it produced. Will we look back someday and observe that Shiller’s research findings had no practical effect as they came at a time when we were collectively setting the stage for stock market highs that would eventually bring on the Second Great Depression?
I think we are advancing. I put the blame for that 44 P/E10 level on the popularity of the Buy-and-Hold strategy. The Buy-and-Holders assured investors that the insanely high price levels of the late 1990s meant nothing, that stocks always remain a sound long-term investment, rendering us price-indifferent. I think it would be fair to say that the primary appeal of the Buy-and-Hold strategy is the Get Rich Quick component of it — this idea that prices don’t matter, that stock investors can collectively vote themselves big raises and never pay a price for doing so.
But there’s another way of looking at things. Buy-and-Hold is promoted as a research-based strategy. That’s not really what it is. There is no research showing that it is not necessary to practice price discipline when buying stocks. That’s just a story that Buy-and-Holders tell to themselves as well as to others. But while I believe that the Get Rich Quick element of the Buy-and-Hold concept is a big part of its appeal, I don’t think it’s right to say that that is the only factor pushing millions of good and smart people toward a belief in the strategy. Millions believe that Buy-and-Hold is research-based regardless. It’s a very good sign for the future that so many of us long to make use of research to guide our stock investing strategies.
I see the popularity of Buy-and-Hold as a precursor to something very different. I foresee true research-based strategies achieving the dominance that Buy-and-Hold achieved in the days of crazy high prices in the days following the crash that will show us all in stark and scary terms the long-term pitfalls of following Buy-and-Hold strategies.
Today’s stock investors are in the process of developing self-knowledge. We are getting close to the point where we will be able to see how emotional we have become about stock investing just by looking at the P/E10 level and seeing how out of whack we have collectively permitted it to become. We are in the process of learning how to keep our Get Rich Quick impulse in check and for the first time in stock-market history to act in our true self-interest.
Stock investors are certainly not capable of rational behavior today, as the Buy-and-Holders like to claim we are. But we are getting there.
Rob’s bio is here.