The stock market is comprised of humans.
It’s obvious. No one can dispute this. It doesn’t need to be said.
And yet it does. We know that the stock market is comprised of humans. But we forget.
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We fall into thinking that the market is comprised of super-smart non-emotional beings who price stocks as they should be priced. That’s the Efficient Market Theory. We tell ourselves that story because we want to think that our retirement money is in the hands of experts. We hate to think that the value of our life savings is being set by ordinary people who don’t have time to study these matters in depth, by people like us. It’s scary to think that it is people like us who are controlling what happens to our money — such people are not qualified for this important job!
John Bogle has written that: “I know of no serious academic, professional money manager, trained security analyst, or intelligent individual investor who would disagree with the thrust of the Efficient Market Hypothesis: The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap.” The headline to this article is my response. The stock market is not a demanding taskmaster. The stock market is comprised of humans. A good number of them know next to nothing about stock investing. Many of the humans who comprise the stock market invest in stocks because they have no choice -- they want to be able to retire someday and they have been told that they must invest in stocks to have any hope of doing so. So they invest in stocks. But they have little interest in learning about the subject of stock investing. They are not demanding taskmasters.
Smart people invest in stocks too. Of course. But there is no rule saying that only smart people can invest in stocks. Nor is there any rule saying that smart people must always comprise a majority of investors. I’m not sure that even generally smart people could be smart enough to make the stock market a demanding taskmaster. A good number of the realities of stock investing are counter-intuitive. A smart person could be led to believe that the number on his portfolio statement tells him the real and lasting value of his investment. That’s not so, according to Shiller’s research. When stocks are priced at two times fair value, half of the amount reflected in that portfolio statement number is the product of irrational exuberance and possesses no lasting value. That one trips up lots of generally smart people. Lots of generally smart people do not behave in smart ways in the stock investing realm.
And even if they did, could they counter the influence of the many less-than-smart investors? I have had Buy-and-Holders come to my website and argue that it is not possible for me to use the cyclically adjusted price earnings (CAPE) ratio to predict future stock returns. If it were so easy to gain an edge, all investors would do it, they tell me. All investors are out to gain every edge they can get, I am told. As Bogle would put it, we are all demanding taskmasters. If you believe that, then it is true that the fact that not all investors follow valuation-informed strategies proves that valuation-informed strategies don’t work. It’s a circular argument that makes sense only if you buy into the premise that the stock market is comprised of super-humans who are not subject to the intellectual and emotional deficiencies that we see exhibited by the humans in every other type of endeavor in which they partake.
Bogle 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.” The historical record of stock prices shows that investors who have managed to see through the crazy ups and downs of stock prices have been doing better than those who have failed to do so since the day that the market opened for business. To be sure, they haven’t been able to do it “readily.” It can take 10 years or even a bit longer for rationality to assert itself in the formation of stock prices. But it does always happen. There has never been an exception.
It’s that reality that is the demanding taskmaster, in my assessment. Bogle said that we should avoid market timing because it is foolish to believe that we can know the true price of stocks better than the market does. I say that we should avoid accepting overpricing as real because it is foolish to believe that the market is getting the price right even when the CAPE value is insanely high. Bogle had confidence in the market. I have confidence in the pull exerted by the fair-value CAPE number. He saw the market price as real. I see the valuation-adjusted market price as real. I think that you need to add that valuation adjustment to take the investor emotion that is temporarily throwing the numbers off out of the mix.
The market is comprised of humans. We are the market. We flatter ourselves when we describe ourselves as demanding taskmasters. We can be rational. We are capable of being demanding taskmasters. But it is not automatically so. It takes work. With each moment of time that we devote to considering the effect of valuations we become less emotional and more rational and make the market more efficient than it would be if we followed Buy-and-Hold strategies. Paradoxically, it is the widespread belief in Buy-and-Hold that renders Buy-and-Hold dangerous. It is when large numbers of investors come to believe that the market is comprised of super-human beings that stock prices go completely out of whack and the market becomes very easy to beat indeed (by stepping aside from its craziness for a time).
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