Buy-and-Hold is the dominant stock investment strategy today. I don’t support it. I support Valuation-Informed Indexing. There’s only one difference between the two strategies. Buy-and-Hold is a thrill ride. Valuation-Informed Indexing isn’t.
We call the transactions by which stocks are bought and sold a “market.” But that’s not entirely accurate. In a market, the people making purchases and sales inform themselves about how much they should be willing to pay before agreeing to transactions. There’s a good bit of that in the stock market. But most investors are largely uninformed about the critical matter of the effect of valuations.
Do valuations affect long-term returns? For a long time it was thought that they did not. There was a widespread belief among economists that the market is efficient. That would mean that investors make rational choices aimed at advancing their self-interest. If that were so, there would be no mispricing. So valuations would be irrelevant. Market timing would serve no purpose.
Robert Shiller published research in 1981 showing that those economists were wrong. The market is not efficient. Investors often act in highly emotional ways. Valuations affect long-term returns. Valuation-based market timing is needed to get prices back to fair-value levels. Without market timing we will see runaway bull markets followed by price crashes and economic collapses.
But we haven’t changed how we invest! We’re still going about it in the same way we did before Shiller published his amazing research. Today’s CAPE value is 37, more than double the fair-value CAPE of 17. Few are alarmed. Rarely do you see comment on this frightening reality.
We’ve gotten accustomed to the thrill ride. The market has been operating in the same manner for so long that we have come to believe that it’s the only way it could operate. Not so! Shiller was awarded a Nobel prize for his research because it tells us something important. What it tells us is that the market operates as it does not because that’s the only possibility but because our lack of knowledge of the realities caused us to invest in ways that frequently caused the market to become dysfunctional.
The title of Shiller’s book is “Irrational Exuberance.” Investors don’t only bid up stock prices to reflect the effect of economic growth. They also bid them up just because it feels good to see bigger numbers on their portfolio statement. Investors have the power to set stock prices wherever they like. So they at times set them artificially high. The prices of course need to come down over time so that they again reflect the economic realities (the core purpose of a market is to set prices properly). The artificial ups and inevitable follow-up downs turn stock investing into a thrill-ride experience for millions of investors who would prefer a more stable means of financing their retirement.
Can we bring the thrill ride to an end? Sure. It would be easy. All that we would need to do is to educate investors about how much less appealing it is to own stocks when prices are super high. A regression analysis of the historical return data shows that the most likely 10-year annualized return when stocks are priced as they were in 2000 is a negative 1 percent real while it is a positive 15 percent real when stocks are priced as they were in 1982. It wouldn’t be too difficult to persuade investors to lower their stock allocation when the asset class into which they were putting their retirement money was offering a negative return. The stock sales that resulted would pull prices back to more reasonable levels.
We don’t do that today. If we were to tell investors how important it is to practice market timing, we would be telling them that the Buy-and-Holders got it wrong, which wouldn’t make the Buy-and-Holders happy. And there would be a price crash soon after we transmitted that message. If stock prices fell by 50 percent over the next few months, the loss of consumer buying power that resulted would bring on a recession. Stock investing would be less of a thrill ride from that point forward. But there would be some rough waters to cross in the immediate aftermath of the change in advice. Shiller’s research offers powerful insights but not popular ones at times when the CAPE value resides where it resides today.
The CAPE value will fall someday on its own. It always does. Insanely high stock prices are inherently unstable. So that will happen. It’s not possible to say when it will happen. That’s what everyone wants to know. We cannot say when but we can say that sooner or later it will happen. And we can say that, when it does, it is going to hurt.
My hope and my expectation is that that hurt is going to prompt some of us to reconsider the now optional thrill-ride aspect of the stock investing experience. Take away the thrill ride and stocks would still offer an annual return of 6.5 percent real. That amount of return is justified by the economic realities. I think it’s a great return. It’s only the greedy desire for a return greater than that that makes the thrill-ride experience such a consistent element of the stock investing experience. I could live without it. I have come to believe from talking with thousands of ordinary investors that I am far from being the only one who feels that way.
