Valuation-Informed Indexing #53: All Stock Investors Believe That Returns Are Predictable (Some Just Don’t Want to Admit It)

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by Rob Bennett

There’s only one difference between Buy-and-Holders and Valuation-Informed Indexers. Valuation-Informed Indexers look at valuation levels to predict their long-term return before buying stocks. Buy-and-Holders do not do this.

Buy-and-Holders often ridicule Valuation-Informed Indexers over their belief in their ability to predict stock returns. Do we employ crystal balls? Do we just go with our feelings? Have we never looked at the academic research showing that predictions don’t work?

The reality is — All investors predict their returns before putting money on the table. A rational being cannot give up the use of his or her money without first forming some idea in his or her mind as to what he or she is going to obtain in return. Are we to believe that Buy-and-Holders have no idea of whether their stock investments are going to work out or not?

If they really believed that, investing to them would be pure gambling. When you buy a lottery ticket, you are indulging a fantasy and you don’t care much about the odds. When you put money you have saved to provide for retirement to work for you, you have some idea in mind as to how good a job it is going to do.

The reality is that the Buy-and-Holders predict returns every bit as much as Valuation-Informed Indexer do, they just don’t like to be specific about the predictions they are employing. What Buy-and-Holders are thinking is that the stocks they buy will likely provide a long-term return of something in the neighborhood of the average 30-year return for U.S. stocks — 6.5 percent real.

The reality, of course, is very different. The long-term return is the 10-year return. The likely long-term return when stocks are priced where they were priced in 1982 is 15 percent real. The likely long-term return when stocks are priced where they were priced in 2000 is a negative 1 percent real. A return of 15 percent is not a return of 6.5 percent. Nor is a return of a negative 1 percent a return of 6.5 percent. Buy-and-Holders are dreamers.

Some will view that as an odd thing for me to say. Buy-and-Holders like to cite studies making use of historical data. They argue that they follow a scientific approach to investing. Data-based investing is the opposite of fantasy-based investing, the argument goes.

What Buy-and-Holders have done is to combine the fantasy Get Rich Quick approach of the past with the data-based, research-supported approach of the future. In the old days, stock investing was not a subject of systematic academic study. So just about everyone was following a fantasy Get Rich Quick approach (the exception was the Value Investors, who were going to the trouble of analyzing particular companies and investing only in those that offered a a strong long-term value proposition). The Buy-and-Holders took an important step forward by rooting their strategies in something real and objective, the historical return data and academic studies of what it says.

Their mistake was in failing to incorporate the most important price of the investing puzzle — valuations, the thing that determines whether an index fund offers a strong long-term value proposition or not — into their calculations. The result is that all of the studies generated pursuant to the Buy-and-Hold model get all the numbers wrong. Buy-and-Holders have wrong numbers to go by when setting their stock allocations, wrong numbers to go by when structuring their retirement accounts, and wrong numbers to go by when assessing risks. It’s a big mess!

They know this on some level of consciousness. That’s why they are so reluctant to be clear about their predictions of how stocks will perform on a going-forward basis. If they were to make intellectually justifiable return predictions, they would need to consider valuations because this is the dominant factor. But the effect of valuations on long-term returns is the Achilles heal of Buy-and-Hold strategies. Start talking about valuations frankly and the entire model collapses.

So the Buy-and-Holders comfort themselves that return predictions are not possible, that predictions are the product of some sort of magic and are in some way less “scientific” than the numbers in all their studies. No. Predictions are required. There is no investor more irresponsible than the investor who tries to convince himself that he will be the first in history to fail to form an intelligent assessment of his future return and not pay a big price for the failure.

Buy-and-Holders live in denial. They are trapped. To fail to talk about valuations is to fail to talk about investor emotions (all overvaluation and all undervaluation is caused by investor emotion). It is investor emotion and the role it plays in causing us all to make poor decisions that is the primary risk of stock investing. The Buy-and-Hold fear of discussing the most important aspect of the investing puzzle causes those following this approach to suffer to a greater extent than other investors the effects of investor emotion. Stock investing is riskier for Buy-and-Holders than it is for any other type of investor.

This is why I often say that Buy-and-Hold is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind. It’s not that Buy-and-Holders were the first to pursue fantasy-rooted strategies. It’s that Buy-and-Holders were the first to pursue fantasy-rooted strategies in the sincere belief that those strategies were supported by legitimate academic research.

It’s one thing to follow a fantasy. That will get you into trouble. But it’s something much worse to follow a fantasy in the belief that the fantasy is the product of scientific investigation. Many Buy-and-Holders vow to stock to their strategy until they have lost everything. I doubt it will go that far. But I do think it is likely that it will be when the Buy-and-Holders finally sell that the market will achieve capitulation and stocks will begin offering solid long-term returns once again.

Rob Bennett argues that, when stock prices are high, cash is king (and he’s got the numbers to prove it!). His bio is here.


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