Buy-and-Hold is a wealth destroyer. I believe that.
Most people do not. I know that because the CAPE value today is 37. It would not be possible for the CAPE value to rise so high unless most people were following Buy-and-Hold (no price discipline, no market timing) strategies. Most people obviously do not want to employ strategies that destroy wealth. So what’s the deal?
The deal is that Buy-and-Hold destroys wealth only very slowly. So slowly that people do not notice it while it is happening. People don’t think of Buy-and-Hold as a wealth destroyer.
If anything, people think just the opposite, they see Buy-and-Hold as a wealth generator. Buy-and-Hold posits that market timing is a bad idea. If that were so, Buy-and-Hold would be a sound strategy because it helps people to avoid market timing.
There’s one type of market timing that really doesn’t work, the type where you guess the direction in which prices will go over the next month or the next year or whatever. I am entirely with the Buy-and-Holders re that one. I do not believe that the guessing-game approach to market timing works. I think the Buy-and-Holders are helping people by discouraging the guessing-game approach to market timing.
The approach to market timing that I support is valuation-based market timing. This is where you adjust your stock allocation in response to big price swings with the aim of keeping your risk profile constant over time. A regression analysis of the historical return data shows that the most likely 10-year annualized return on stocks when they were priced as they were in 2000 was a negative 1 percent real while it is 15 percent real when they are priced as they were in 1982. Risk is obviously much greater when the likely return is a negative 1 percent real. So the investor who wants to keep his risk profile constant over time (to Stay the Course in a meaningful way) needs to practice valuation-based market timing.
I am the co-author of peer-reviewed research showing that valuation-based market timing always works. It always reduces risk while also always increasing one’s long-term return. It’s not hard to understand why. Stocks offer a better deal when they are priced reasonably compared to when they are priced insanely high. The investor who goes with a lower stock allocation when stocks are priced insanely high loses less in the inevitable price crash. So he is able to own more stocks when stocks are priced insanely low. He does better across the board. At the end of 30 years, he is often ahead of the Buy-and-Holder by hundreds of thousands of dollars.
You would think that everyone would be investing this way. But it’s tricky.
It really does always produce good results at the end of 30 years. But most of us don’t focus on what is good for us 30 years down the road. If we did, we would exercise more and take better care of our teeth and eat less sugars and carbs. We respond to negative reinforcement that descends on us quickly after we engage in problematic behavior. Bad results that we don’t see for 30 years often don’t influence our thinking very much.
Buy-and-Hold destroys wealth. How? It fools us as to the real value of our stock portfolio. Stocks are today priced at more than two times their true and lasting value. The woman walking around thinking that she has $1 million put away really has $500,000 put away. The guy who believes his portfolio statement when it tells him that he possesses $100,000 in stock wealth really possesses $50,000 in lasting stock wealth. Not knowing the true value of your stock portfolio has devastating consequences. It undermines one’s ability to engage in effective financial planning. One makes all sorts of bad decisions when one does not have a good idea of where one stands financially.
Irrational exuberance is a wealth destroyer. That’s another way of saying it. If we were all thinking clearly, we would all want to practice valuation-based market timing. Valuation-based market timing is the enemy of irrational exuberance. We create irrational exuberance because we want to fool ourselves about the value of our stock portfolio. Valuation-based market timing pulls prices back to where they should be. It’s hard for investors to fool themselves about the value of their portfolio in a world in which valuation-based market timing is widely practiced and widely encouraged.
I’d like to see us move to a world in which that is done. Robert Shiller published his Nobel-prize-winning research showing that valuations affect long-term returns in 1981. It’s time.
The trouble that I face is that the wealth destruction that is taking place as the result of today’s phony prices is taking place slowly, gradually. Most people are not alarmed by it. They might sometimes experience some concerns when they hear that valuations are high. But they look at their portfolio statement and they are reassured. Things seem to be going well. They assure themselves that some people just worry too much.
I don’t buy into the idea that the wealth destruction takes place only when prices crash. A price crash takes place when investors recognize the wealth destruction that has been taking place for the length of the bull market. The wealth destruction results from all of the bad decisions that are made because investors do not know the true value of their stock portfolio. But until we start printing on the portfolio statement a second line showing the value of the portfolio adjusted for the effect of the amount of irrational exuberance present in the stock price at that time, people are not going to see it.
Buy-and-Hold is a wealth destroyer. The intelligent thing to do is to adjust one’s stock allocation to the extent needed to keep one’s risk profile constant over time. But the wealth destruction takes place only slowly, gradually. Buy-and-Hold is sneaky mean.
