Putting More Focus on Valuations Would Make Indexing More Popular

 Valuation-Informed Indexing #398

By Rob Bennett

There are lots of people who don’t like to invest their retirement money in stocks. You don’t hear about them much at investing sites because the types of people who are drawn to investing sites are generally not the types of people who are afraid to invest in stocks. But there are lots of ordinary people who must invest their Section 401(k) contributions if they ever hope to be able to retire who do not feel comfortable putting much of that money in stocks. A good number of them have confided in me over the years. There are more of them out there than most of us realize.

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It would be great for the investing advice industry if we could persuade these people to invest in stocks, would it not? It would mean that people working in this field could sell more books and could earn more commissions and just generally could have more positive impact on this world. It would also of course be a big plus if the frightened investors could get over their fears. Stocks are an amazing asset class, one that none of us should be missing out on. If there were something that we could do  that could persuade millions of people to feel better about investing their retirement money in stocks, we should be doing it.

I think that there is something that we could do. I think that we should all be talking more about how dangerous stocks become when valuations rise to high levels.

Your first reaction is probably that it doesn’t seem like that would help. It is the price volatility of stocks that scares people. How is talking more about price volatility going to ease their fears?

I hinted at the reason in the headline for a column that I wrote here a few weeks back — “Fama Gave Us a Beautiful Car with a Powerful Engine, Shiller Provided the Brakes.” Stocks offer an amazing value proposition at all times except when prices rise too high and at those times stocks offer a very poor value proposition indeed. The entire historical record of stock prices shows that. It’s true that we turn people off stocks a bit when we tell them how much people hurt themselves when they invest heavily in stocks at times of high valuations. But we do something else when we do that — we provide a means by which prices can be corrected. It is by scaring people when prices start to get a little high that we prevent them from getting so high as to become truly scary.

If we talked more frequently and more boldly about the dangers of overvaluation, it would become a less common and a less serious problem. Imagine a world in which the dangers of smoking were rarely mentioned. There would be more smoking in such a world. Which means that there would be more cancer deaths. Which would obviously not be a good thing. We should be stressing the dangers of overpriced stocks for the same reason. We should encourage stock ownership but only when stock ownership is a positive, not when prices are so high as to make stock ownership dangerous.

What happens when stock prices rise so high as to bring on a crash? People lose money, of course But it’s not just that. When people lose large portions of their life savings in a crash, they lose confidence in the stock asset class itself. Most people don’t understand that it is only when stocks are high-priced that they become dangerous. People who suffer through a crash swear off the asset class and become reluctant to invest in stocks even when they are selling at perfectly reasonable prices. These investors lose at both ends. They see large portions of their life savings disappear because they buy into the hoopla about stocks when they are dangerous and then they miss out on the benefits of stocks when the dangers are close to nonexistent.

Shiller’s research suggests a powerful marketing argument. Shiller showed that price drops can be predicted (not in the short term, but in the long term). If investors were told in advance when lasting price drops were coming (when prices are high!), they could step aside from them and thereby opt out of the one big downside of stock ownership. And thereby get over their fears of investing in this great asset class and become happy lifelong buyers of reasonably priced stocks.

There’s no downside.

Actually, there is one. Let investors know when stocks have become dangerous and for a time people will buy less of them. That downside is only a temporary one. Fail to tell people when stocks have become dangerous and you lose their trust when they suffer the consequences of their ignorance. It takes a long time to regain trust that has been lost in that way. We would all be better off if we talked frankly about the dangers of overpriced stocks and thereby rendered the overpricing of stocks a far less frequent and a far less severe problem.

Rob’s bio is here.