Stocks are overpriced today. No one disputes that. There are differences of opinion as to the extent of the overvaluation problem. But I don’t think that there is anyone who would say that there is no overvaluation issue at all.
So stocks are a less appealing asset class today than they would be if they were priced properly. That follows, doesn’t it? Can there be any argument with that one?
There are people who will not buy into that claim. Lots of them. And they are smart people too. It drives me more than a little bonkers that there are so many smart people who will not acknowledge what to me is an obvious truth. But that’s the reality.
I have asked my Buy-and-Hold friends to explain. They say that, when stocks are priced high, it makes sense to expect lower returns in future years. That certainly makes sense. But it seems to me that an asset class that offers lower returns is a less appealing asset class. So people should go with lower stock allocations at times of high valuations. Whatever one’s stock allocation is at a time when stocks are priced fairly, It should be something less at a time when stocks are priced higher and the expected return is lower.
This my Buy-and-Hold friends do not accept. If you change your stock allocation in response to shifts in valuation levels, you are engaging in market timing and that’s bad. That’s their thought. It makes no sense to me. My thought is that it is your risk profile that you want to keep constant and that, if you need to adjust your stock allocation from time to time to do that, then that’s what you should do. Whether that qualifies as a form of market timing or not (I believe that it is fair to say that it does) shouldn’t matter. The important thing is to keep your risk profile roughly constant over time.
But most experts in the field don’t agree with me. And most ordinary investors do not agree with me. I feel compelled to try to figure out why. Why is there this widespread aversion to the idea of exercising price discipline (engaging in long-term market timing) when buying stocks?
I think that Robert Shiller has come as close as anyone to offering a convincing explanation. Shiller has said: “There is a growing behavioral economics movement, but it has so far had limited impact. Economists are not fond of the softness and imprecision of psychology. These notions are considered vaguely unprofessional and flaky.”
Those three sentences describe the divide between Buy-and-Hold and Valuation-Informed Indexing. There is a mountain of evidence showing that human psychology influences stock prices. But the Buy-and-Holders just do not want to go there. They don’t want to look at the evidence showing that they could reduce stock investing risk while increasing their investment return by being willing to take psychology into consideration. Because accepting that psychology affects stock prices is -- scary.
Say that evidence existed that astrology works. Say that scientists came forward saying that we all should check out our astrological reading for the day and permit it to influence the decisions we make during the course of that day. I would be extremely uncomfortable doing that. If my reading said “do not take on financial commitments today,” I would feel foolish if I let that persuade me not to take out a mortgage or to buy a season ticket to attend Phillies games. I would feel like I was abandoning the use of human reason to go down that road.
I think that that’s how Buy-and-Holders feel about the idea of believing that long-term stock prices are predictable, as Shiller has shown. How could it be? If people knew in advance what stock prices were going to be 10 years down the road, they would take advantage of that information and their efforts to take advantage would change prices enough so that the predictions would no longer work. Overvaluation is an impossibility to the logical, reasoning mind. Shiller’s research findings are “unprofessional and flaky.”
They are. I understand the objection that Buy-and-Holders have to Shiller’s findings. It just doesn’t seem plausible that long-term stock returns are highly predictable. Taking human psychology into account takes one into a realm that is “soft” and “imprecise.” Stock investing is a serious business. It is an area in which you want to place your trust in hard numbers and not in any of this emotional gobbledygook .
I obviously think that Shiller is onto something. I am comfortable thinking of investors as highly irrational creatures because I accept that they are humans and for my entire lifetime I have witnessed the humans engaging in highly irrational behavior. But I try to be understanding when my Buy-and-Hold friends evidence repulsion at my advocacy of investing insights that to their minds are rooted in something akin to astrology. It requires a giant leap of faith to move from the Buy-and-Hold belief in Rational Man economics to Shiller’s exploration of a very different kind of science.
I recall the comment of one of the members of one of the peer-review committees that rejected the research paper that I co-authored with Wade Pfau showing the superiority of Valuation-Informed Indexing over Buy-and-Hold. This fellow said: “The elephant-in-the-room question is — What is the ultimate criterion for one to conclude with confidence that one strategy is better than the other?” This comment has always touched me because it evidences an honest struggle in the man’s heart as to what to do. The suggestion is that he saw merit in the paper. But he just could not bring himself to give his seal of approval to something that to his eyes looked an awful lot like astrology.
I think that the only thing that could bring me around to believing in astrology would be a good explanation of WHY it works. Without that, I just cannot grant plausibility to claims that it does work. I believe that Shiller has offered a good explanation of why Valuation-Informed Indexing works in his book Irrational Exuberance. It clicks for me. I suspect that my Buy-and-Hold friends just find the core idea too “unprofessional” and “imprecise” and “flaky” to give the book a careful read or to ponder the ideas set forth in it seriously enough for them to leave much of a mark.
Rob’s bio is here.