Investors Hurt Themselves in the Long Run By Bringing on Excessive Price Gains in the Short Run

caused by irrational exuberanceSoulMusic / Pixabay

I argued in my article from two weeks ago that Buy-and-Hold remains popular today because the strategy has performed well in the post-Shiller era. From 1981 forward, the S&P 500 has provided an annualized real return of 8.1 percent. I also noted that on the one occasion on which shocking losses caused a number of Buy-and-Holders to begin to lose confidence in the strategy (the days following the 2008 price crash), prices quickly recovered. The return for the past 10 years has been 11.2 percent. The other side of the story is that the annualized real return for the past 20 years is only 3.7 percent, well below the average stock market return of 6.5 percent real.

Most investors could not cite these numbers. Most form their opinion as to whether the strategy is working or not by forming an impression of whether or not their portfolio is growing over time by the amount that they need it to grow by to finance their retirement. Most have probably noticed that for the past two decades stocks have been providing sub-par returns. But they have also noticed that for the past 10 years and for the past 40 years returns have been outstanding. So the overall impression is that Buy-and-Hold gets the job done and then some.

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But, if Shiller is right that high stock prices are caused by irrational exuberance, prices will be returning to fair-value levels in the not-too-distant future. That would mean a price drop of 50 percent or more. At the end of earlier bull/bear cycles, the CAPE level dropped to “8.” That would be a price drop of more than 70 percent. And that price drop would likely remain in place far longer than the one we saw in 2008. Will such devastating losses cause the general impression of the efficacy of the Buy-and-Hold strategy to change?

I believe that they will.

The difference between Valuation-Informed Indexing and Buy-and-Hold is that Valuation-Informed Indexing takes the long view. Prices always return to fair-value levels. There has never yet been an exception to this rule. So Valuation-Informed Indexers do not count price increases that take prices beyond fair-value levels as real. In the short term, Buy-and-Hold appears better because it permits investors to indulge their fantasy belief that price gains resulting from overvaluation are every bit as solid as price gains resulting from economic developments. In the long term, only economic gains count. Buy-and-Hold makes effective financial planning impossible because it confuses investors as to the value of their portfolio.

When people say that they like Buy-and-Hold, what they are really saying is that they like owning a share of the powerful U.S. economic growth engine. It is that growth engine that is responsible for the 6.5 percent real returns enjoyed by stock investors. The Buy-and-Hold opposition to market timing adds nothing to the equation. Price indifference causes super high returns for a time and then the super low returns that always follow as the market works its way back to reasonable price levels. Both the super-high-return time-periods and the super-low-return time-periods cause huge inefficiencies both for millions of individual investors and for the economy as a whole.

Can I afford two weeks of vacation this year or only one? Should I buy a new car or get by a bit longer with the one I already own? Should I encourage my child to attend a state university or tell her to feel free to attend a more expenssive out-of-state one? Investors ask themselves questions of this sort on an almost weekly basis. To analyze these questions properly, they of course need to know how much they have in savings. It is of course impossible to know for so long as we live in a world in which stocks are often priced at two times fair value or more, as they have been for much of the past 23 years.

And the huge upward and downward price swings that are characteristic of a stock market in which most investors are following Buy-and-Hold strategies cause major distortions. Businesses incur the costs of expansions because the numbers support the idea and then see the expansion fail because stock prices fall hard and cause consumer spending to dry up.

Wouldn’t it be better if we could all possess a better idea of the real and lasting value of our stock portfolios? We could have that if we would just acknowledge that price gains caused by irrational exuberance never last. There’s all the difference in the world between economic-based stock gains and investor-emotion-based stock gains. If we would encourage investors to appreciate the difference between the two, many would do so and price volatility would be dramatically diminished.

I believe that the next price crash will cause investors to question the merit of the Buy-and-Hold concept. We gain nothing by letting prices rise to unsustainable levels and then shock us with the dramatic collapses that always follow such price rises. Practicing price discipline when buying stocks is a more realistic and more efficient approach.

Rob’s bio is here.

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About the Author

robbennett
Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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