By Rob Bennett
When people talk about stock investing today, they almost always are discussing an issue relating to economics. Perhaps they are explaining that an increase in productivity is supporting an extension of the bull market. Or perhaps they are speculating that an increase in interest rates might cause a price pullback. Every now and again, someone will make a brief reference to something relating to investor emotions. But the focus is on the hard stuff — numbers, numbers generated by economic developments.
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Shiller changed all that. Not in a practical, real-world sense, just yet. But in a theoretical sense, Shiller changed all that. His 1981 finding that valuations affect long-term returns will in time shift the focus from economics to investor emotions.
Stock prices rose by 126 percent from January 1996 through January 2000. If you believe that the market is efficient (that investors are pursuing their self-interest in a rational way in their setting of stock prices), that’s exciting stuff. That means that the economy was sufficiently productive during those four years to double the size of the retirement portfolios of millions of investors. We all were a lot better off at the end of those four years than we were at the beginning of them. The super bull was something to celebrate. And most of us did indeed celebrate our apparent good fortune at the time.
But what if Shiller is right? What if it was not an economic upturn that brought on those huge price gains but just irrational exuberance, just a passing wave of out-of-control investor emotion? If that were so, there was nothing to celebrate at all. If Shiller is right, there was no reason to believe that the economy was performing better during those four years than it performs in most other four-year time-periods. And if Shiller is right, we hurt ourselves by letting the bull market get so out of control. We fooled ourselves about how much we had in our retirement portfolios, making financial planning more difficult. We caused businesses to hire workers that they would not be able to retain for long. We borrowed gains from the future that we would need to pay back in later years.
That’s the basic story. Shiller is saying that Buy-and-Hold was a mistake. I have never heard him say those precise words. But it seems to me that that is very much the implicit message of his Nobel-prize-winning work. If valuations affect long-term returns, the market is not efficient and stock investing risk is not static but variable. If stock investing risk is variable, investors obviously need to be adjusting their stock allocations in response to big price shifts to keep their risk profiles roughly stable over time.
Shiller’s research stands our old understanding of how stock investing works on it head. It changes everything. In the post-Shiller era, we cannot afford to think about any strategic issue in the same way that we thought about it in the pre-Shiller era.
Say that you were trying to decide on a stock allocation in January 1996, just before prices took off. You didn’t know where things were headed. Say that you went with a moderate stock allocation, perhaps 50 percent. As prices rocketed upward over the next four years, you might have experienced a twinge of regret that you had not taken a bigger bet on stocks. If you attributed the gains to economic growth, as most Buy-and-Holders do, you might have kicked yourself for selling the U.S. economic growth engine short. We live in a highly productive economic system. The stock market offers an easy means for ordinary people to participate in it. Why not go with the highest stock allocation consistent with the dictates of middle-class responsibility, perhaps 80 percent rather than 50 percent?
That’s how an investor who came to learn about how stock investing works by reading articles rooted in a belief in Eugene Fama’s research might have reacted to those amazing gains at the tail end of the 20th Century. An investor steeped in articles exploring Shiller’s research in great depth would have come to very different conclusions.
The Shiller investor would have been frightened by those gains. He would not have seen them as something to celebrate; he would likely have characterized them as “out of control.” All investors want the market to be as rational as possible; we have our retirement money invested in it. The difference, though, is that Buy-and-Holders see nothing concerning about big price gains — they are caused by economic developments as much as are small gains. Valuation-Informed Indexers, in contrast, see bull-market gains as emotion-generated gains. Times of high valuations are times of irrational exuberance. The times in which the market delivers big gains are the most dangerous times for stock investors.
The difference in outlook changes every decision that the investor makes. I believe that making the shift from the Buy-and-Hold perspective to the Valuation-Informed Indexing perspective empowers the investor.
A Buy-and-Hold investor wants big gains. But he has no control over whether the market delivers them or not. The Buy-and-Hold investor believes that it is the economy that determines how the market performs and no investor has control over the direction in which the economy moves. We can hope for good times. We cannot influence whether or not they appear.
It doesn’t work that way for Valuation-Informed Indexers. We don’t have control over whether stock prices move up or down either. But we do believe that we can know in advance which way things will be moving in the long-term. Remember, valuations affect long-term returns. We know that the value proposition of stocks is stronger for stock purchases made at times of low prices and weaker for stock purchases made at times of high prices. We cannot change the behavior of other investors. Bull markets and bear markets will take place whether we approve of them or not. But we can step out of the way when the investor emotions that determine stock prices get too out of hand. We can lower our stock allocations at times of runaway bulls and thereby keep our risk profile at all times where we intended it to be when we decided on it. When most other investors are losing their heads, we can keep ours locked on tight.
It’s not just individual investors who are empowered by a shift to investment strategies rooted in Shiller’s research. Investors are collectively empowered in the post-Shiller era. None of us like the losses that the market delivers in bear markets. Until now, we accepted those losses as the natural consequence of owning stocks, as an unfortunate reality that we could not change. But, if Shiller is right, we can insure that there is never another bear market that will come along to mess with our retirement dreams. If valuations affect long-term returns, the way to stop the poor returns that come with bear markets is to stop the high valuations that come with bull markets. If we are willing to give up bull markets, we can eliminate the conditions that cause bear markets to develop.
What is the appeal of bull markets? There really is none to the investor possessing a deep understanding of Shiller’s work. Bull markets are an illusion. If valuations affect long-term returns, every percentage point of gain greater than the gain that would be enjoyed had prices remained at fair-value levels must be paid back in subsequent years. The only reason why bull markets came to be celebrated in earlier times is that we did not yet have available to us the research we needed to know what caused them.
Rob’s bio is here.