Investing Strategies That Ignore the Effects of Stock Crashes Cannot Work

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Valuation-Informed Indexing #199

by Rob Bennett

A few week back I wrote about how I do not like Robert Shiller’s explanation of why short-term timing never works and long-term timing always does. Shiller said that this is because there is “noise” in the price results we see in the short term that is eliminated by the time we reach the long term. I see that as an unfortunate way of explaining things because it suggests that investor emotion — the “noise” that causes prices to vary from what they would be if the market always reflected the economic realities — is a trivial factor.

Investor emotion is not a triviality. Investor emotion is the giant missing piece in our understanding of how stock investing works. Investor emotion behaves according to observable principles. It is by studying how investor emotion affects stock prices that we can come to know far better than we do today how to diminish risk and how to become truly effective long-term investors.

I thought it might be helpful to expand on the comments offered in the earlier column by exploring two of these principles in a bit more depth:

Investor Emotion Is Predictable

I am 57. I have something in the neighborhood of 30 years of stock investing ahead of me. How will prices act during those three decades???If the Buy-and-Hold Model were legitimate, I would have no way of knowing. The Buy-and-Hold Model posits that it is unforeseen economic developments that cause stock price changes. Unforeseen economic developments are by definition unpredictable. So, if I believed in Buy-and-Hold, the only thing that I could say about how stock prices will play out over the remaining years of my investing lifetime is that the average long-term return will probably be something in the neighborhood of 6.5 percent real. The details would be totally unknown to me.

The precise details remain unknown to me as a Valuation-Informed Indexer. I cannot tell you the date when we will see the next price crash or the date when prices will turn permanently up again or the date when the next bull market will peak. But I CAN say a lot about how prices will behave over the next three decades.

Prices always go up and up and up until we reach a P/E10 level of 25 or higher and then come down sharply until we reach a P/E10 level of 8 or lower. There’s never been an exception to that rule for 140 years. Not because economic developments have been following the same pattern for the entire history of the U.S. market. Because investor psychology has been the same.

Shifts in investor emotions are predictable while changes in economic realities are not. It follows that Shiller’s discovery that it is investor psychology that is the dominant cause of stock price changes takes us from a world in which future stock prices are unknown to a world in which future stock prices are to a large extent (but not to a complete extent, of course) known in advance.

Investor Emotion Can Change Direction in a Hard and Sudden Manner

You really only need to know one thing about stock market history to know that the market is not efficient. Prices crash from time to time. If prices were determined by economic realities, there would be ups and downs in prices. But there would never be crashes. The market lost over $9 trillion in value in the 2008 crash. There is zero chance that informed investors had in late 2008 taken note of changes in the economic realities serious enough to justify that sort of change. The market crashed because market prices are determined primarily by shifts in investor emotions and one of the characteristics of emotions is that they change suddenly and harshly.

Emotions are not rooted in logic. So they can do just about any crazy thing. It is critical that those studying stock investing come to a better appreciation of this seemingly obvious implication of Shiller’s “revolutionary” (his word) finding. When I tell people that the numbers show that it was the relentless promotion of Buy-and-Hold strategies that served as the primary cause of the economic crisis, they find it a hard reality to take in.

It doesn’t make sense! Surely investors would not let prices get so out of hand as to cause $12 trillion of consumer buying power to disappear from the economy as prices worked their way back to fair-value levels. No, it doesn’t make sense. But bull markets aren’t supposed to make sense. They are an emotional phenomenon, not a rational one. What would make sense is for the P/E10 always to remain at 15, the fair-value P/E10 number. Higher P/E10 values signify the presence of unhealthy levels of investor emotion and we need to pay attention to those readings if we are to invest effectively for the long-term and to avoid the sorts of economic crises that have followed every secular bull market experienced over the 140 years of stock market history available to us today.

So long as stock market prices are determined by emotional phenomena, we are going to see terrifying price crashes and the terrifying economic crises that inevitably follow from them. The other and more positive way of stating it is that, now that we are aware that market prices are determined by emotional phenomena, we are empowered to avoid crashes and economic crises by educating investors as to how they need to respond to bull-market prices to win higher lifetime returns and earlier retirements for themselves.

Crashes are a big deal. A price crash can cancel out years or in some cases even decades of saving efforts. So investors need to learn how to “play” crashes. They need to stop focusing on short-term results and incorporate into their financial planning thoughts on how to avoid the pain of being heavily invested in stocks when the price crash that all investors see at some point in their investing lifetimes evidences itself for them personally.

Crashes are a logical impossibility under the Buy-and-Hold Model. So of course not much attention is paid to them in the conventional literature. That needs to change. A model that takes note of the role played by investor psychology in setting stock prices will naturally direct a good bit of attention to the phenomenon of the stock crash, a phenomenon that will remain central to the stock investing experience UNTIL it is understood well enough to be avoided.

Rob Bennett has recorded a podcast titled The Equity Risk Premium Explained at Last! (Perhaps). His bio is here.


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