I say a lot of things that annoy my Buy-and-Hold friends. It’s not my intent to annoy them. I was once a Buy-and-Holder myself. So I certainly appreciate the appeal of the strategy. And I think that Buy-and-Hold was a big advance over what came before it. I believe in science. And Buy-and-Hold was developed as a scientific approach; John Bogle recommended that investors root their investment decisions in the findings of the peer-reviewed research. Still, I lost confidence in Buy-and-Hold a number of years ago and now often criticize it.
My guess is that the thing that I say that most annoys my Buy-and-Hold friends is that it is a Get Rich Quick strategy. Buy-and-Holders disdain Get Rich Quick thinking. I believe that they are 100 percent sincere in their expressions of this disdain. Yet I really do believe that the Get Rich Quick element of the strategy is one of the biggest reasons for its popularity. So I think it might be helpful for me to explain why I say that such an element is indeed a part of the strategy.
The following is our rough coverage of the 2021 Sohn Investment Conference, which is being held virtually and features Brad Gerstner, Bill Gurley, Octahedron's Ram Parameswaran, Glenernie's Andrew Nunneley, and Lux's Josh Wolfe. Q1 2021 hedge fund letters, conferences and more Keep checking back as we will be updating this post as the conference goes Read More
Eugene Fama published research in the 1960s purporting to show that the stock market is “efficient.” That means that prices are developed through a rational process. Positive economic developments cause prices to rise and negative economic developments cause prices to drop. The price assigned to stocks by the market is rooted in something real.
Shiller published research in the 1980s showing something very different. His research showed that the market is not efficient, that prices are not determined by economic developments but by investor emotion (irrational exuberance or irrational depression). So, according to Shiller, stock prices are not rooted in something real to the extent that they rise above or drop below fair-value levels.
That’s the difference between the two strategies. It’s a big difference with many far-reaching implications.
If Fama is right, stock investing risk is a constant. How could any one investor know better than the market as a whole what the price of stocks should be? Since you cannot outsmart the market, all that you can do in deciding on a stock allocation is to assess how strong of a value proposition is offered by stocks in general. There are no better or worse times in which to own stocks.
However, if Shiller is right,stock investing risk is variable. The P/E10 level that applies tells the investor the amount of emotional content present in the market price at that time. Stocks offer a better long-term value proposition at low prices than they do at high prices. So informed investors adjust their stock allocation in response to big price shifts to keep their risk profile roughly constant over time.
Who sets stock prices? We do. Investors do.
Do we want to set prices properly? Not really. Not any more than we want to get paid properly for the work we do. We all would like to get paid more than we are worth. We of course do not have that option available to us since independent actors determine what we are paid. But we do set the price of our stocks. If we collectively elect to double or triple the value of our stock holdings, who can stop us?
The stock market is inherently a Get Rich Quick scheme. The people who would benefit from higher prices have the power to move prices higher.
The complication is that there is a natural brake on price increases -- the reality principle. We cannot elect to send prices higher and higher and higher. At some point, prices get so high as to alarm the market (us!) and it sends them back down again. So price increases beyond those justified by the economic realities (that is, beyond those that set prices at fair-market-value levels) do not last. When we set prices too high, we are borrowing from our own futures. We are permitting ourselves to live high today by impoverishing our futures.
The market can do a good job of setting prices only for so long as investors react negatively to excessive price increases by lowering their stock allocations. It is through the stock sales that take place when investors lower their stock allocations that prices are pulled back to where they should be.
Buy-and-Holders do not believe in changing their stock allocation in response to big price shifts. They fail to do the job that all investors need to do to keep the market functioning properly. They thereby do away with the brake on runaway prices that otherwise would always keep prices at reasonable levels. They encourage investors to give in to their irrational exuberance and bid prices up to levels that eventually bring on the price crashes that do so much harm to all of us.
Buy-and-Holders do not think of themselves as Get Rich Quickers. They think of themselves as taking a neutral position re the goings on in the market by sticking to a single stock allocation at all times. And they see no problem with doing so because they believe that the price established by the market always represents something real. But, if Shiller is right that high prices are the product of irrational exuberance, it is the lack of alarm re high prices felt by the Buy-and-Holders that permit prices to climb to dangerous levels.
Buy-and-Holders disdain Get Rich Quick thinking. But they fail to see that sticking to the same stock allocation when prices rise dramatically encourages an escalation in prices that could never take place if they were aiming to keep their risk profile constant over time.
Rob’s bio is here.