There are two schools of academic thought as to how stock investing works, Buy-and-Hold (which everybody knows about) and Valuation-Informed Indexing (the school of thought rooted in the research of Robert Shiller). Few investors even know that Buy-and-Hold has even been challenged. For most of us, the idea that market timing is a bad idea is as well-established as the idea that the earth is not flat but round. The idea that market timing is the key to long-term investing success (the core principle of Valuation-Informed Indexing) is an absurdity.
How did that come to be the reality? Shiller was awarded a Nobel prize for his research showing that valuations affect long-term returns. If that is so, then stocks are obviously more risky when valuations are high and the investor who wants to keep his risk profile roughly constant over time has no option but to practice market timing. It would be understandable if there were differences of opinion on the question of whether market timing is a good thing or not. But it is an exceedingly strange reality that most investors are not even aware that there is a good bit of solid research showing that long-term market timing always works.
I believe that the cause of the confusion is that the difference between the two models is so stark. The term that academics use to describe the shift from Buy-and-Hold to Valuation-Informed Indexing is “paradigm change.” If it is true that valuations affect long-term returns, then nothing that we once believed about how stock investing works is valid. Just for starters, we cannot trust our portfolio statement to reveal the true value of our stock holdings. If overvaluation is the product of irrational exuberance rather than the product of a rational assessment of economic realities, we all need to divide the number on our portfolio statement by two to know the true value of our stock holdings at times when stocks are priced as they are today.
I am often asked how this situation came to be. Was there a great conspiracy in which everyone who works in the investment advice field agreed to keep discussion of the realities from us?
I am generally skeptical of conspiracy theories. I think that a better explanation of the strange reality is that our confusion over how stock investing works is the result of one of the most widespread cases of cognitive dissonance ever experienced. Shiller published his research and it attracted a good bit of attention. But most of us continued thinking about stock investing in the same way in which we did before he came along all the same. Shiller’s message did not implant itself into our brains because our filters found it too radical for serious consideration.
Cognitive dissonance has been described as “the discomfort felt by a person who holds conflicting ideas, beliefs or values at the same time.” It’s not possible for the same person to believe in both the research of Eugene Fama (in which the Buy-and-Hold strategy is rooted) and of Robert Shiller. A stock portfolio cannot be worth both $200,000 and $100,000 at the same time. And it is of course not possible to form opinions about any investment strategy question without first determining the value of one’s stock holdings. Those who believe in Buy-and-Hold walk one path and those who believe in Valuation-Informed Indexing walk another.
The unfortunate thing is that we need to hear the two sides talking to each other to learn which has the better case. But is it possible for someone who believes in Fama’s research to engage in respectful and friendly discussions with someone who believes in Shiller’s research? It is possible. I have been engaged in such discussions on numerous occasions. But respectful and friendly discussions between Buy-and-Holders and Valuation-Informed Indexers are not the norm. Tell someone that his stock portfolio is worth only 50 percent of the amount that he sincerely thinks it is worth and the usual response you are going to see is consternation. Shiller’s research findings are startling.
The conditions were perfect for widespread cognitive dissonance when Shiller published his first research challenging the Buy-and-Hold dogmas in 1981. One, Buy-and-Hold had already become the dominant academic theory for explaining how stock investing works at that time. Two, the question of how stock investing works is obviously not only a matter of academic study; the practical aspects of the question are of great concern. By 1981, there were many people making a living based on their expertise re the Buy-and-Hold Model. Discredit the model and you would discredit these people’s livelihoods. There were many people in positions of influence who had strong personal reasons for feeling skepticism about Shiller’s findings.
Three, stock prices were at rock-bottom lows in 1981. That meant that it was easy to dismiss Shiller’s concern over the effects of overvaluation. Those who were not inclined to replace the Buy-and-Hold Model could tell themselves that there was little chance that stocks would ever again be priced at fair-market levels much less at levels much greater than that. So there was little sense of urgency re the project of incorporation of Shiller’s findings into the widely accepted understanding of how stock investing works. And, by the time prices reached dangerous levels in the mid-1990s, most in the field had already been generally ignoring Shiller’s findings for over a decade and felt embarrassment over the idea of acknowledging at that late date that there was new research that cast doubt about many of the strategies that they had been advocating for years.
Shiller’s research constitutes a major advance. We know today many important things about how stock investing works that we did not know in earlier times. But for practical purposes we do not know those things. Few of us have yet been able to integrate Shiller’s research findings into our thinking about this important subject matter.
Rob’s bio is here.