Robert Shiller has described the intellectual leap from the finding that short-term price changes are unpredictable to the Efficient Market Theory belief that the market sets prices properly as “one of the most remarkable errors in the history of economics.” That’s my take. I view the Efficient Market Theory as a mistake, a mistake that was revealed to be a mistake with the publication of Shiller’s Nobel-prize-winning research. And so I have a hard time understanding why Buy-and-Hold — an investment strategy that makes sense in my eyes only for those who still believe in the Efficient Market Theory — remains so popular.
If valuations affect long-term returns, if stock investing risk is not constant but variable, if price matters as much when buying stocks as it does when buying anything else — Buy-and-Hold simply does not make sense. Does it?
John Bogle is the biggest advocate of Buy-and-Hold alive on Planet Earth today. And he is someone whose writings I respect a greal deal. So I often ponder how he can continue to believe what he believes. Is there something that Bogle understands that I have not yet picked up on?
I don’t have the sense that the issue is that Bogle is a dogmatic believer in the Efficient Market Theory. He has said that: “Whatever the consensus on the Efficient Market Hypothesis (EMH), I know of no serious academic, professional money manager, trained security analyst, or intelligent individual investor who would disagree with the thrust of EMH: The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap.”
He has also said that: “While the apostles of the new so-called “behavioral” theory present ample evidence of how often human beings make irrational financial decisions, it remains to be seen whether these decisions lead to predictable errors that create systematic mispricings upon which rational investors can readily (and economically) capitalize.”
Both of those comments evidence an acceptance that the Efficient Market Theory is not perfect truth. Bogle believes that there is “ample evidence” that humans make irrational financial decisions. So investors are certainly not always 100 percent rational in their investment choices, as the theory posits. And Bogle acknowledges that there is something less than a complete consensus supporting the Efficient Market Theory today.
On top of that, Bogle has indicated that he believes that there might be times when it would be appropriate for investors to change their stock allocations by as much as 15 percent in response to shifts in valuation levels. I wouldn’t call that enthusiastic support for the Valuation-Informed Indexing concept. But it is certainly a tentative step in the direction of support for a valuation-informed strategy. My sense is that Bogle believes in the Efficient Market Theory in a general way but is less than completely dogmatic in his belief.
I certainly favor the avoidance of dogmatism. So that part is good. But I have a hard time understanding where Bogle is coming from with his skepticism as to whether the irrational financial decisions made by investors “lead to predictable errors that create systematic mispricings upon which rational investors can readily (and economically) capitalize.” Whenever stocks are priced at something other than their fair value, a mispricing has taken place from which rational investors can capitalize. If mispricing is real, it causes stocks to be either more risky or less risky than they would be if they were priced properly. The rational investor aims to keep his risk profiles constant over time. So he adjusts his stock allocation to compensate for the increased or diminished risk that the asset class he is purchasing carries with it.
The tricky word in that quote is “readily.” If Bogle is saying that investors who change their stock allocation in response to big valuation shifts may not see benefits for doing so for 10 years or perhaps in some cases even a bit longer, I certainly agree. Perhaps we agree! But I don’t want to jump to that happy conclusion. He also says that: “The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap.” The historical stock return data shows that an investor who went with a stock allocation of 60 percent when prices were at moderate levels, a stock allocation of 30 percent when prices were insanely high and a stock allocation of 90 percent when prices were insanely low would obtain higher returns at less risk than an investor who stuck with a 60 percent stock allocation at all times. Would making that sort of change be such a “high hurdle” for an investor to leap?
The only hurdle that I see is that the investor choosing the valuation-informed path would need to do so in the face of differing views on the value of stocks held by the majority of investors. When stocks are priced insanely high, it is because most investors have made choices based on a belief that those insanely high prices are appropriate. The investor who elects to lower his stock allocation when prices rise is swimming counter to the prevailing currents of investor opinion. He is going low when most investors go high and high when most investors go low. Is it a “high hurdle” for an investor to become a bit of a contrarian?
That certainly is the case today. Most of us want to feel safe about our retirement money. To step outside the conventional opinion about the current value of stocks is a scary business. So Bogle is not entirely wrong in what he says here.
But it seems to me that it is the promotion of Buy-and-Hold dogmas as they are currently taught that is a big part of the problem. What if it became common practice for investment advisors to stress to investors the need to practice price discipline when buying stocks as much as they practice it when buying anything else? Then investors would no longer face a :high hurdle” when following valuation-informed strategies. They would enjoy higher returns while taking on less risk. And stock prices would be far less volatile.
My view is that the Efficient Market Theory is almost right by not quite right. It assumes investor rationality. I think that investor rationality is something to be sought but not something to be assumed. Investors are capable of rationality. But they must fight the urge to accept the apparent wealth gains that seem to follow from unjustified price increases as real. Buy-and-Hold as it is currently promoted encourages investors in this illusion. If we all made an effort to be more rational (to be price conscious when buying stocks), the market would be a lot more efficient than it is today.
It’s not that investors are not capable of rationality. It’s that the Buy-and-Hold dogmas discourage them from doing the emotional work that they need to do to achieve the goal of efficiency. We are the market. So the market will always be as efficient as we make it. The more that the investment advice we hear stresses the need for price discipline when buying stocks, the better off we all will be.
Rob’s bio is here.