What is my beef with Buy-and-Hold? It’s that it is a discipline indifferent strategy. If you don’t time the market, you are going with the same stock allocation regardless of the price at which stocks are selling. That makes no sense. How could price not matter? We consider price when buying everything else we buy. How could it be a good idea to ignore it when it comes to buying stocks? It’s worse than that. Buy-and-Holders aren’t just price indifferent. They are outright hostile to the idea of exercising price discipline when buying stocks.
They say that timing doesn’t work (this is true of short-term timing but not of long-term timing). They suggest that investors who elect to lower their stock allocation at times when prices are high will somehow “miss out” on stock gains as a result. To my mind, practicing long-term market timing is exercising price discipline. I have a hard time imagining how exercising price discipline could cause me to miss out on anything good. It is of course possible that stocks could provide good returns even starting from times when they are overpriced.
But I would be taking on more risk to obtain those returns. So long as results are assessed on a risk-adjusted basis (as they always should be, in my view), it is a logical impossibility that long-term timing could ever not work.
But the poor results that Buy-and-Hold offers to the individuals who follow the strategy is only the small part of the story. The more significant downside is what a widespread belief in Buy-and-Hold does to the market as a whole and to the economy as a whole and ultimately to the confidence that citizens of our nation have in our system of government.
Robert Shiller predicted the 2008 economic crisis. He stated in March 2000 that: ““If, over some interval in the first decade or so of the twenty-first Century, the U.S. stock market is going to follow an uneven course down, as well it might – back, let us say, to its levels in the mid-1990s or even lower – then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.” It was the widespread promotion of the Buy-and-Hold strategy that pushed stock prices high enough to cause him to advance that warning.
Tens of thousands of entrepreneurs saw their businesses fail in that economic crisis. Millions of workers lost their jobs. And millions saw their hopes for financial security in their old age diminished. Investment strategies that discourage price discipline cause a lot of pain for the unfortunate humans taken in by them.
I’ve written here before about the craziness of price crashes. It’s understandable that we would see prices go up a bit at times and down a bit at times. But price drops that cause trillions of dollars of wealth to disappear overnight should simply never happen. Such price dops cannot be explained rationally. They are the product of shifts in investor emotion. And it is the “idea” that it is not necessary to practice price discipline that makes investors so emotional as to cause such price drops. The human mind is not capable of ever fully accepting the idea that price doesn’t matter when buying stocks. Sooner or later, confidence in that idea fails and the pretend gains caused by years of price indifference go “Poof!”
Price discipline is what makes markets work. The core job of a market is to get prices right. The reason why capitalism is a more productive system than communism is that prices are set by a small number of people in a communist economy while the brains of millions of consumers collectively set prices in a capitalist economy. Our system works better than the competition because our system sets prices better.
Exercising price discipline in a fluctuating market
We toss that advantage away in our stock market. When investors are taught that it makes no difference whether stocks are priced at one-half of fair value or at fair value or at two times fair value or at three times fair value, the market is not able to impose any penalty for mispricing. That might seem like a good thing in the short term. But it is a very bad thing in the long term. The entire history of the market shows that eventually it will set prices properly, at a CAPE value of about 16.
The longer that magic is delayed, the harder it is to accept the change when it comes. If we all exercised price discipline on a daily basis, price levels could never move too far from fair-value levels and we would never have to endure the pain associated with a long bear market. That would be a better world.
I often wonder why it is that so many smart and good people see no problem with an investment strategy that rules out the exercise of price discipline as a core principle. I believe that there are two things going on. One, there can be a long delay between the time when prices first get out of hand and when the market resets them to more reasonable levels; prices got out of hand in 1996, more than 20 years ago. And, two, it makes strong intuitive sense to believe that the numbers on one’s portfolio statement reflect reality.
Exercising price discipline and today’s investors
If Shiller is right that valuations affect long-term returns, today’s portfolio statement numbers overstate the real and lasting value of our stock holdings by 100 percent (stocks are today prices at two times their fair value). That’s a reality that is hard and scary to accept, regardless of how many decades of peer-reviewed research support it.
Shiller has described the intellectual leap from the finding that short-term price changes are unpredictable (University of Chicago Economics Professor Eugene Fama showed this in research published in the 1960s) to the Buy-and-Hold belief that the market sets prices properly as “one of the most remarkable errors in the history of economics.”
Andrew Smithers, co-author of Valuing Wall Street, has written: “It is sad that the idea that price doesn’t matter…should ever have been seriously considered.” Price discipline is essential to the proper functioning of all markets. The stock market is not the first exception to this universal rule, despite anything that our Buy-and-Hold friends say about the subject.
Rob’s bio is here.