Valuation-Informed Indexing #395 on how stock investing works and its connection to Adam Smith and Eugene Fama
By Rob Bennett
Buy-and-Hold is “sticky.” It is my view that Robert Shiller’s 1981 research showing that valuations affect long-term returns discredited the efficient market theory, which is the core belief of the Buy-and-Holders. So Buy-and-Hold should have passed from the scene by now. At the very least, we should see it being challenged everywhere it is promoted.
But that is not even a tiny bit the case. Few investors are dogmatic Buy-and-Holders. But the vast majority believe at least somewhat in the core principles of Buy-and-Hold. When a newcomer to investing goes looking for a simple description of the basics of stock investing, he is almost certainly going to be told some version of the Buy-and-Hold story. The Buy-and-Hold model for understanding how stock investing works remains dominant today.
Why? I need to have an answer to that question. I would like to see Valuation-Informed Indexing (the model rooted in Shiller’s research rather than in Fama’s) become dominant. This does not seem even close to happening 37 years after Shiller published his “revolutionary” (Shiller’s word) research findings, research that caused Shiller to be awarded a Nobel prize in 2013. What’s going on?
The biggest reason is that Buy-and-Hold tells investors that their portfolios are worth more than they really are at times of overvaluation. We have been at very high price levels for over two decades and investors naturally enjoy being told that their accumulated wealth is greater than it is. So it is understandable that Valuation-Informed Indexing has not caught on with the general population of investors.
But how about with the experts? Experts in this field obviously follow developments in the peer-reviewed research. They know about Shiller’s Nobel prize. They understand that their job is not to tell people what they want to hear but to offer informed views as to how stock investing works in the real world. Why are there not more experts singing the praises of Valuation-Informed Indexing and warning of the dangers of Buy-and-Hold?
I think that a big reason for the delay in the spread of Shiller’s ideas is that the alternative to Shiller’s model — Buy-and-Hold — has roots that go very deep. Eugene Fama is the economist who did the most to lend theoretical support to the Buy-and-Hold Model. But the general way of thinking about how money transactions work that informs the Buy-and-Hold Model really began with Adam Smith and Adam Smith’s ideas inform the thinking of every economist alive. When an economist is asked to question his belief in Buy-and-Hold, there is a very real sense in which he is being asked to question his belief in things he learned in the first textbooks on economics that he ever read.
It was Adam Smith who promoted the concept of a “Rational Man” who makes the economic choices that best advance his self-interest. Isn’t that what Buy-and-Hold is all about? Buy-and-Holders believe that the market is efficient, that is, that it is always properly priced. Why is the market properly priced? Because we are all acting in our self-interest. If some of us noticed that the others of us had priced stocks improperly, we would swoop in and exploit the mispricing to our benefit. The reason why Buy-and-Holders believe that it is not possible for market timing to work is that one can successfully time the market only by outsmarting it and it is hard to imagine how anyone could be smarter than a market of millions each acting rationally in pursuit of his or her self-interest.
Shiller is saying something very different. He is saying that it is shifts in investor emotions, not economic realities, that are the primary drivers of stock price changes. Investors who permit emotion to steer their investing choices are not acting in their self-interest, they are acting irrationally. Of course they are not even aware that they are failing to act in their self-interest. In the Shiller model, investors hurt themselves by giving in to emotional impulses to push stock prices ever higher and individual investors who possess the ability to see through the irrational exuberance can indeed profit by being smarter than an overall market that is not very smart at all,
This is a big, big, big, big change in perspective. The question of what causes stock price changes is fundamental. And the implications of Shiller’s Nobel-prize-winning findings are far-reaching indeed. If Fama is right, the stock market is a safe place to put one’s retirement money given that human reason rules the day under this understanding of how the market works. Shiller’s vision is a frightening one to someone with a longstanding belief in Adam Smith economics. If Shiller is right, the numbers on our portfolio statements do not reflect hard economic realities but only the passing fancies of millions of emotion-filled investors.
An economics professor once told me that I should not expect to see Valuation-Informed Indexing gain serious ground on Buy-and-Hold until we experience a “paradigm change,” something that probably can only be brought on by a deepening economic crisis. For experts in this field to give up their confidence in Buy-and-Hold, they have to question things that they have subscribed to as basic truths for as long as they have been earning a living doing work as economists. Shiller’s ideas challenge everything that we once believed about how stock investing works. That’s why they excite me so. But that’s also why they face such a struggle gaining a foothold among the experts and ultimately among the general population of investors.
Rob’s bio is here.