Great Intelligence Does Not Protect an Investor from Emotion Traps

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A fellow named “David” called me on Sunday and to talk about Valuation-Informed Indexing. He is a big believer in the merit of Shiller’s research and has read several of the articles that I have posted at this site. He wanted to know a bit more about my suggestions for the implementation of a Valuation-Informed Indexing strategy.

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Stock Investing Risk Is Constant

I tried to keep the explanation simple. I pointed out that Buy-and-Holders believe that stock investing risk is constant. Thus, investors do not need to change their stock allocation in response to changes in valuations. The root idea here is that investors are rational. Rational investors would set stock prices to reflect the economic realities. So stock prices are always roughly right, never dangerous.

Valuation-Informed Indexers, in contrast, believe that Shiller’s research showing that stock investing is a highly emotional endeavor is legitimate research. Risk varies according to the CAPE level that applies. An investor seeking to keep his risk profile roughly constant over time must adjust his stock allocation in response to big shifts in valuation levels.

I suggested to David that, if his Buy-and-Hold allocation was 60 percent stocks, he might instead want to go with a 60 percent stock allocation when the CAPE value was between 12 and 21 and with a 90 percent stock allocation when the CAPE value is below 12 and with a 30 percent stock allocation when the CAPE is above 21.

The High Valuation Levels Of U.S. Equities

David said that he is avoiding U.S. equities today because of the high valuation levels that apply. But he still goes with a high stock allocation, investing in index funds in countries in which the CAPE level is reasonable. I said that that sounded like an intelligent approach and that Shiller has indicated that he follows a similar approach. I said that I did not believe that such an approach would be suitable for the average investor but that I thought that it made sense for someone with the skill and time needed to do the necessary research.

However, as our talk continued, we found an issue on which we were in strong disagreement. I told David that, while his own portfolio might perform well, the high valuations that apply in the United States might still cause him harm because of the damage that they could do to our economic system. I noted that every earlier bull/bear cycle has ended with a CAPE value of 8. That would be a 70 percent drop from where prices stand today. That sort of price crash would cause such economic devastation that it might bring on a Second Great Depression. No one could entirely avoid the negative consequences of such an event.

David dismissed the idea that we could ever again see a CAPE value that low. In fact, he views the idea that we will ever again see a CAPE value below 21 as at least somewhat outlandish. He said that he did not expect that I would see a CAPE value below 21 in the remaining years of my lifetime. I find that a shocking assessment. The median CAPE value is 16. That means that in half of the years for which we have records of stock prices the CAPE has been below 16. On what basis could someone conclude that we will never again go below 21?

Smartest People In The World Are Not Overly Concerned About Today's Stock Prices

David argued that "the smartest people in the world" are not overly concerned about today’s stock prices. If they were, they would speak out about the dangers and, given their influence, might well be able to pull prices down a bit. I granted that that follows. Lots of smart people are not nearly as concerned about today’s stock prices as I am.

I do not find that comforting. I noted to David that the people responsible for the Enron catastrophe were the smartest people in the room in every room in which they were found. Their intelligence did not prevent them from making terrible mistakes. Intelligence is generally a plus. There’s no question about that. But intelligence can only protect us from certain kinds of dangers and not from others.

Shiller showed that stock investing is a highly emotional business. That is what made his research so “revolutionary” (his word). That is why he was awarded a Nobel prize. That is where he parted company with the Buy-and-Holders. If the Buy-and-Holders are right about how stock investing works, intelligence really could protect us from making catastrophic mistakes. But, if Shiller is right, intelligence cannot protect us. If Shiller is right, intelligence may be a negative.

Rationalizing Emotional Investment Decision

When humans make emotional choices, they like to justify them in their minds. This is called “rationalizing.” The more intelligent a human is, the greater is his capacity to engage in rationalization. The smartest people in the world are more likely to be taken in by their rationalizations of high prices than any of the rest of us because their rationalizations are so well-constructed that it is hard to see the holes in them.

The worlds of reason and of emotion are different worlds. For those who have never dug deep to appreciate the far-reaching implications of Shiller’s work, the stock market remains a reason-dominated world, one in which people of high intelligence would be sure to speak out if we ever permitted valuations to rise so high as to put our futures at risk. But to someone who has spent years saturating himself in the idea that irrational exuberance is a real thing, the lack of alarm on the part of the experts re our current stock prices offers small comfort.

If today’s stock prices were a threat to our economic future, the smartest people in the world wouldn’t see it. They are in the habit of directing their mental energies to the rational aspects of the stock investing project. There’s nothing rational about today’s CAPE level. The smartest people in the room hardly take note of it. The idea that stock prices are determined by investor emotion doesn’t compute for them.

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