Valuation-Informed Indexing #394
By Rob Bennett
Buy-and-Hold is the common-sense investing strategy. Isn’t it?
I obviously do not believe that. I advocate Valuation-Informed Indexing and Valuation-Informed Indexing could fairly be described as the opposite of Buy-and-Hold. The two strategies are identical in many ways but are rooted in different beliefs re what causes stock price changes. Buy-and-Holders believe that price changes are caused by economic developments. Valuation-Informed Indexers believe that they are caused by shifts in investor emotion. That one fundamental difference causes followers of the two strategies to arrive at different conclusions re just about every strategic question that comes up.
I don’t believe that Buy-and-Hold is common sense. But I believe that the reason why the Buy-and-Hold strategy possesses so much appeal to so many investors is that on first impression it appears to be rooted in common sense. I was once a Buy-and-Holder myself. I know that for me it was the impression that Buy-and-Hold is the common-sense investing strategy that won the day for it.
What I found appealing about Buy-and-Hold in the days when I was drawn to it is that it posited that investors would be better off just tuning out all the “noise” generated by people trying to help people figure out how to invest their retirement money. Investing is a serious business. It frustrated me when I would read one expert saying one thing and another offering a very different take on the same question. If the experts cannot agree, what hope does the ordinary working person have of getting things right? Buy-and-Hold advocates say that most of what the non-Buy-and-Hold experts talk about doesn’t matter much. Invest in an index fund, stick with your plan for the long run, avoid emotional jumps in and out of the market, and you will do fine.
Even today when I write those words, I find myself being pulled in. Buy-and-Hold sounds sensible. It really does.
I have come to believe that Buy-and-Hold is sensible in all respects but one. I don’t believe that the Buy-and-Holders are right to fail to practice price discipline when buying stocks. I agree with them that making emotional jumps in and out of the market is foolishness. But I believe that investors who fail to adjust their stock allocation in response to big price shifts are permitting their risk allocations to get wildly out of whack and I think that that is the least sensible thing that an investor can do. The risks of stock investing are emotional risks. It is only by keeping our risk profiles constant over time that we can have realistic hopes of being able to overcome the emotionalism that throughout history has been doing in stock investors.
Buy-and-Holders don’t see their opposition to long-term timing as a decision to forsake price discipline. They believe that ups and downs counter each other over time and so it is best for the long-term investor to not pay much attention to them. I see it differently. I believe that Robert Shiller is right when he says that it is investor emotion that is the dominant factor in setting stock prices. If that is so, then stocks are a far more risky asset class at times when prices are high than they are at times when prices are reasonable. Investors’ willingness to participate in the stock market should vary depending on how rational or irrational the market is at any given point in time.
What I am proposing is market timing. That’s a dirty word to Buy-and-Holders. I don’t propose short-term market timing. I agree with them that there is no way to know whether prices are heading upward or downward over the next year or two or three. So I disdain the conventional form of market timing as much as they do. I advocate only long-term timing, changing your stock allocation because of a big shift in market prices with an understanding that it could take 10 years or even a bit longer for the move to pay off. The distinction doesn’t impress my Buy-and-Hold friends. To them, market timing is market timing is market timing and it’s always bad.
But who has the better of the common-sense argument on this particular question?
If valuations really do affect long-term returns, as Shiller showed in peer-reviewed research published in 1981, stock investing risk varies with changes in stock valuations. If risk varies, should not the intelligent investor vary his allocation in response to whatever change takes place? It sure seems to me that he should. To fail to do so is to fail to take price into consideration. Not one Buy-and-Holder would advocate failing to take price into consideration when purchasing sweaters or bananas or CD players. Why is it that they cling so fervently to a different rule when it is purchases of stocks that are at question?
I think it is because it is scary to take Shiller’s findings too seriously. Up until 1981, we believed that we investors were engaging in the rational pursuit of our own self-interest when we purchased stocks. That led us to believe that our retirement money was secure despite the crazy ups and downs that took place in the market from time to time. Buy-and-Hold came to be perceived as the sensible strategy because it flattered us into believing that we are always sensible and never irrationally exuberant.
Shiller of course offered a very different take on how the market works. It really is a scary take but only in the beginning. Shiller is telling us that the market is a scarier place than we used to think it was but he is also offering us a way out of the scary stuff. He is suggesting that, if we practice common-sense price discipline when buying stocks just as we do when buying anything else that we can work together to keep those crazy ups and downs from taking place in the first place. The supreme irony of today’s stock market is that our common belief that it is a rational place has served to make it more irrational in recent years than it has ever been before.
Rob’s bio is here.