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

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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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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.

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Shiller’s Breakthrough Was Not to Show Us How Stock Investing Works, It Was to Show Us How to Change How It Works

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What did Robert Shiller do? Practice market timing?

He was awarded a Nobel prize in Economics. He must have made an important contribution to our understanding of how stock investing works. What was it? How did stock investing change as a consequence of Shiller’s research?

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Some would say that he challenged the validity of the Efficient Market Theory (and thus of the Buy-and-Hold Model for understanding how stock investing works). He certainly did that.

Some would say that he showed that valuations affect long-term returns, which is another way of saying that he showed that stock investing risk is not static but variable. That was obviously an important breakthrough.

Did Shiller show us how to practice market timing?

Some would say that he showed us how to time the market effectively. Since risk increases when valuations go higher, investors who want to keep their risk profile roughly constant over time now know that they must adjust their stock allocation in response to big valuation shifts and that they can earn higher returns while taking on less risk by doing so. That’s another big one.

However, Shiller’s biggest contribution was not to show us how stock investing works, it was to show us how to change how stock investing works. Shiller started a conversation that down the road will permit us to gain a level of control over our stock investments that we never possessed before.

I often quote the words from Shiller’s book in which he predicted the 2008 economic crisis. He said 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." The crisis was obviously a scary experience. Hundreds of thousands of businesses went belly up.

Preventing chaos

Millions of workers lost their jobs. We saw political frictions increase. And the saddest thing is that the CAPE level today is back where it was in the days leading up to the 2008 crisis. All signs are that we are headed for a resumption of the 2008 crisis in the not-too-distant future.

It’s good that Shiller’s work helps us to understand what caused the crisis. We need to come to terms with it. And understanding that there has been an economic crisis on every occasion on which large numbers of stock investors became price indifferent certainly helps in that regard.

But Shiller did much more than describe why high stock prices inevitably lead to economic crises. He showed us what we must do to avoid economic crises. He empowered stock investors.

What do we need to do? We need to practice market timing. That’s the answer. Investors practice market timing because they appreciate that stocks offer a stronger value proposition at some times than at others. It is through market timing that investors practice price discipline when buying stocks. And of course price discipline is what makes the market function effectively. Markets in which market timing is not practiced (that is, markets in which Buy-and-Hold thinking has become dominant) always collapse sooner or later. How could they not?

Where we are today

Shiller showed us how to avoid getting into the sort of jam that we are in today. The problem that we face today is that prices are so high that investors react negatively to hearing what the peer-reviewed research tells us about how to identify the true and lasting value of their stock portfolio. Investors would be much more receptive to Shiller’s message if prices were lower. If only Shiller’s model had become dominant before prices got out of hand, they never would have gotten out of hand.

Once prices fall, much of the resistance to Shiller’s research findings will dissipate. From that point forward, we will be free to consider whether market timing is a good idea or not and to what extent we want to practice it. That will be a great liberating moment. From that point forward, it would be hard to imagine how prices could ever again rise to the dangerous levels where they reside today. Investors of course have a desire to act in their best interest.

Once it becomes socially acceptable for experts to point out the dangers of Buy-and-Hold strategies, more and more investors will discover the merit of market timing strategies and prices will never again reach the sorts of levels that bring on a collapse.

Shiller did indeed describe how stock investing works. But his primary accomplishment reaches far beyond the descriptive. He showed us how to make stock investing a less risky and more profitable investing choice. His research does not just describe what is going on in the market. It gives us all the tools we need to change what is going on in a very big and very positive way.

Three cheers for market timing!

Rob’s bio is here.

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