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Did Shiller Change Anything?

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Valuation-Informed Indexing #216

by Rob Bennett

The subtitle to Robert Shiller’s book Irrational Exuberance describes Shiller’s research findings as “revolutionary.”

I agree. If the market is efficient, it makes sense to stay at the same stock allocation at all times because future prices are unpredictable. If valuations affect long-term returns, it is dangerous to stay at the same stock allocation at all times because risk varies with changes in valuation levels. Shiller’s finding that valuations affect long-term returns changes everything.

But how much has the conventional advice on how to invest in stocks changed as a result of the “revolutionary” research that Shiller published in 1981 (and that has been confirmed many times in the three decades since).

Not at all.

If you are able to identify any changes, I’d be grateful if you would point me to them. My sense is that everything is pretty much the same. Shiller’s ideas have not been debated or discredited in any way. They have been ignored.

Some people have looked for a middle ground between the old Buy-and-Hold ideas and the new Valuation-Informed Indexing ideas. But there is no middle ground that can be supported by logic. If the market is efficient, it makes zero sense to change your stock allocation in response to valuation shifts. If valuations affect long-term returns, it makes zero sense to stay at the same allocation at all times. This is a yes or no situation. If Fama’s ideas are right, Shiller’s ideas are dangerous. And if Shiller is right, Fama’s ideas are dangerous.

The problem that those who are seeking a middle ground have is that they do not know how much to change their allocations. Jack Bogle, the King of Buy-and-Hold, once offered advice on this matter. He said that allocation changes are a bad idea. Then he added that investors who feel that they absolutely must change their allocations at times of extreme valuations should limit themselves to allocation changes of 15 percent or less.

Bogle did not say how he came up with the 15 percent number. I can report that he certainly did not use the historical return data as his guide.

The return data shows that the most likely annualized 10-year return when prices are where they were in 1982 is 15 percent real. When prices are where they were in 2000 the number is a negative 1 percent real. In the former circumstance, a stock allocation of 80 percent makes sense. In the latter circumstance, a stock allocation of 20 percent makes. That’s not a 15 percent change. It’s a 60 percent change. Bogle is off by 400 percent.

The reason why Bogle is so far off the mark is that he does not use data or research to guide his advice on stock allocations. Buy-and-Hold is promoted a a research-based strategy. But re this one issue the research and data is thrown out the window. Re this one issue, gut feelings rule with Buy-and-Holders.

This is what needs to change.

Getting the stock allocation right is 80 percent of what it takes to be a successful long-term investor. So we need to encourage investors to use research and data to make stock allocation choices as we encourage them to use research and data to make all other investment-related choices.

If getting the stock allocation right is 80 percent of what it takes to become a successful investor, 80 percent of the advice offered on stock investing should relate to this question of how to decide how much of a stock-allocation change to make when valuations shift. The question that we devote no discussion to today is the investing question to which we should be devoting 80 percent of our energies.

We will get there with a flip of a switch.

We need Bogle to stand on a public stage and to say that he has become aware of a large body of research showing that shows that valuations affect long-term returns and that therefore all investors should at a minimum be giving consideration to the idea of changing their stock allocations in response to big valuation shifts. I of course do not want to put words in Bogle’s mouth. I of course want him to say what he truly believes. But it is impossible for me to imagine that he is not impressed by the large body of research now showing that Shiller is right and concerned that the lead advocates of the investing strategy he promotes have been slow to incorporate strategic ideas based on Shiller’s findings into their advice.

Shiller’s findings changed the world of stock investing advice forever.

So far that has been true only in the intellectual realm and not in the practical world.

The next big step is for us all to stop debating whether or not Shiller’s findings show that allocation changes are needed and turn to debating when those allocation changes are needed and how large they should be.

We need to start taking Shiller’s findings seriously. Giving the guy a Nobel prize is a nice gesture. But Nobel-prize winning ideas that are ignored are Nobel-prize winning ideas that are not generating the practical-world change that they should be generating. Shiller has done his part by teaching us all something important about how stock investing works. We all need to get to work making sure that all investment advisors who want to be taken seriously get about the business of offering ideas on the practical ways in which Shiller’s revolutionary findings change things.

Rob Bennett has recorded a podcast titled Only You Can Prevent Forest Fires — and Bull Markets! His bio is here.

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Rob Bennett

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