Our Ongoing Study of How Stock Investing Works Is Not Taking Place in a Controlled Environment

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This fund run by a SAC Capital alum bought restaurant stocks amid the pandemic

restaurantPrentice Capital Management was up 6.6% for the first four months of the year, compared to the S&P 500's 9.3% decline and the Russell 2000's 21.1% decline. The HFRX Equity Hedge Index was down 9.4% for the quarter. Q1 2020 hedge fund letters, conferences and more Gross and net exposures In his first-quarter letter to […]

I was once a Buy-and-Holder. The thing that appealed to me in the strategy is that it was purported to be rooted in science. I was saving a lot of money at the time and was looking for a way to invest it. I read lots of articles and came to be frustrated that expert opinion was all over the place. One article would say to do “x” and then another would say to never do “x” but both were written by people claiming expertise. True expertise should produce more consistent recommendations more than just not practicing market timing.

The idea behind Buy-and-Hold was to root one’s investment strategy in the peer-reviewed research. That’s science. That’s the hard, objective, numbers-based stuff. It seemed to me that Buy-and-Hold offered more promise to work in the long run than strategies not based on peer-reviewed research.

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Q4 2019 hedge fund letters, conferences and more

Buy-and-Hold let me down. There really is research that at least purports to support most Buy-and-Hold principles. But the support that is offered for the idea that it is not necessary for investors to practice market timing is stunningly weak. Eugene Fama published research in the 1960s showing that short-term timing doesn’t work. The Buy-and-Holders concluded from that that there is no need for investors to practice either short-term timing or long-term timing. Robert Shiller published research a few years later showing that valuations affect long-term returns, which means that long-term timing must work. But the Buy-and-Holders never changed their story. They continue to advise investors to this day to disdain market timing.

That ain’t science! Science is a quest for truth. True scientists don’t ignore evidence that they have made a mistake, they welcome challenges to their tentative conclusions that might help them to discover more productive paths of inquiry. Had the Buy-and-Holders took Shiller’s “revolutionary” (his word) findings to heart back in 1981, when he published them, Buy-and-Hold would be a very different and much more effective strategy today. Outside of the mistaken idea that it is not necessary for investors to practice market timing, the strategy is gold. But that one big mistake cancels out all of the good that Buy-and-Hold would be doing if only it had been corrected. Shiller did the Buy-and-Holders a huge favor by showing them what they needed to change to make all of their other ideas workable in the real world. But that favor has been rejected.

I don’t think it is fair to say that the Buy-and-Holders don’t care about getting it right. My experience has been that they very much care. One reason why they have not corrected the mistake is that the mistake is so big that those who made it experience cognitive dissonance when trying to integrate Shiller’s findings into their understanding of how stock investing works. Another reason is that it is hard to engage in true scientific investigations in this field.

Scientific investigations are supposed to take place in a controlled environment. Scientists engage in painstaking scrutiny of their methodologies to insure that bias is avoided. But it is impossible to avoid bias in the study of stock investing.

The people who prepare the research that we all use to learn how stock investing works own stocks themselves. That biases them! I have not owned stocks since the Summer of 1996, when the CAPE value first rose to dangerously high levels. My critics often make note of this as a way of persuading people listening to our conversations that I am nuts. I do agree that it is a bad idea for investors to go to a zero stock allocation even when prices are very high, as they have been for almost the entire time-period from 1996 forward; I recommend a 30 percent stock allocation when the CAPE value is as high as it has been for most of the past 23 years. But I need to limit the risk I take on with my investments because I am trying to build an internet writing business and that means that my overall “portfolio” contains more risk than is taken on by people who are earning regular salaries. If you presume that I should go with a stock allocation 30 percent lower than what is appropriate for most other investors, then it makes sense that I have been at 0 percent stocks for a long time now.

That biases me! I truly believe in Valuation-Informed Indexing. I have devoted my life to developing and marketing the concept. I believe with my heart, mind and soul. Lots of smart people have found great merit in the case that I make for market timing. But still...

People who read my stuff need to know that I am personally invested in this concept. If Buy-and-Hold turns out to be a wonderful strategy, I am going to look very foolish. So I have a strong motivation to see bad in Buy-and-Hold and good in Valuation-Informed Indexing. I aim to keep bias out of my writings. But the reality is that no human being is capable of pulling that off perfectly. I am certain that I miss things that I would notice if I did not possess such a strong personal need for Valuation-Informed Indexing to be the real thing.

Doesn’t that go for the people who write about Buy-and-Hold as well? If a researcher who is writing a paper that presents Buy-and-Hold in a positive light is counting on his 70 percent stock allocation to finance his retirement, he is going to miss things that he would notice if had had never purchased stocks himself. His personal investment choices bias the research that he performs whether he wants thdm to or not and whether he is aware of the effect of the bias or not.

And of course that 23-year time-period during which stocks have been selling at dangerously high prices is the longest time-period in the history of the U.S. market at which prices have remained that high. So the bias that most of us feel in favor of stocks is today the strongest that it has ever been. The research that is done on stock investing is not being done in a controlled environment. It is being done in a highly biased environment.

We need to try to maintain a skeptical perspective when considering the findings of that research. The dictates of the scientific process demand it.

Rob’s bio is here.