It’s the Irrationality of Mispricing That Makes Long-Term Returns So Predictable

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The Buy-and-Holders see me as their enemy. I advocate market timing. They hate it. So they see me as someone who views their ideas on how stock investing works as misguided.

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The reality is that I believe that the vast majority of the work done by the Buy-and-Holders is of great value. Deep in my heart, I think of myself as a Buy-and-Holder. It is only on one issue that I have a disagreement with them. So I think a lot about why me and my Buy-and-Hold friends have come to such a different perspective on that one issue.

Is The Stock Market Unpredictable?

The Buy-and-Holders view the stock market as unpredictable, The reason is that the market as a whole is smarter than any one individual investor. No matter how hard that investor works it or how intelligent that investor is, he is unlikely to be able to form a better assessment than the one formed by the market as a whole. I agree with all that. I generally think that the Buy-and-Holders are right to advise investors not to try to outsmart the market.

But there’s one exception.

I believe that it is possible to outsmart the market when it comes to valuations. High valuations tell us that low returns are coming. Low prices tell us that high returns are coming. It’s been that way since the market opened for business. It shouldn’t be that way. But it is that way and it has always been that way.

It shouldn’t be that way because, if returns were predictable, the market should take into consideration the information that makes predictions possible and incorporate that information into its assessment of the value of the market. Which would change the price. Stock prices are self-regulating so long as investors behave rationally.

Correlation Between Mispricing Stocks And Predictable Stock Prices

The problem is -- investors are not capable of rational behavior! We like to think we are. So the Buy-and-Hold dogmas flatter us. But the reality is that investors are human and humans are not entirely rational creatures. We are at times highly emotional creatures. There are times when we are so emotional that we price stocks at one-half of their fair value and there are other times when we are so emotional that we price stocks at two times their fair value. The more we go crazy in mispricing stocks either on the high side or the low side, the more predictable stock prices become (because prices always return to fair-value levels).

Prices are super high now. So we know that prices will be coming down hard in coming years. Returns will be low. So why don’t we just accept that stocks are not an appealing asset class today, pay less for them, and thereby pull the price down to more reasonable levels?

Because we don’t want to!

We like the big numbers on our portfolio statement. Big numbers possess more appeal than moderate numbers. So we are not willing to do the rational thing and pull prices down. In this care, it is entirely possible for the investor who keeps his emotions in check to be a lot smarter than the market as a whole. All that you need to have today to be a whole big bunch smarter than the market as a whole is a little bit of common sense.

Please note that I did not say that you can become smarter than the market as a whole by going to school and taking classes or by managing mutual funds or by having decades of experience investing in stocks. None of those things is likely to help. In many cases, those things will make it harder for you to outsmart the market because they will make it more likely that you will fall into the traps that have been ruining intellectually smart investors for a long, long time.

Emotional Intelligence

To become smarter than the market, you need emotional intelligence, not intellectual intelligence. It’s a different sort of thing. People with a great deal of intellectual intelligence are often suspicious of emotional intelligence. Robert Shiller has observed that: “Economists are not fond of the softness and imprecision of psychology. These notions are considered vaguely unprofessional and flaky.”

My Buy-and-Hold friends say that I am flakey when I say that stock prices are highly predictable and that therefore market timing is a good idea. I think that they are caught in a trap. They believe that being rational is the key to successful long-term investing. But it is only when we recognize that our intellectual intelligence has its limits that we can open our minds to the lessons that only emotional intelligence can provide.

The Buy-and-Holders are smart. That’s their downfall. They are too smart to see the weaknesses of a purely rational approach to stock investing. Investing is done by humans and humans are emotional creatures. Stock investing cannot be fully understood by those who try to take a purely rational approach to the subject.

Rob’s bio is here.