There once was a time when it was widely believed that the stock market was “efficient.” This is something that the economists came up with. It means that investors are engaged in the rational pursuit of their self-interest. If that were so, stocks would always be properly priced.
If the price got too high or too low, an investor would rush in to profit from the mistake. That would restore prices to their proper place.
Stock Investing Risk Is Not Constant
It sounds plausible, doesn’t it? People have their hopes for the future riding on how their stock portfolio performs. It would sure make sense of them to be as rational as possible in the decisions they made about it.
And all of the things that the Buy-and-Holders say about stock investing follow from this premise. If the market is efficient (that is, if investors are 100 percent rational), stock investing risk is stable. There is no way to know in advance how stock prices are going to perform in the future. Attempts to do so are nothing more than guesswork. Market timing cannot work.
I don’t believe any of that.
I don’t find fault with the Buy-and-Holders for coming up with the ideas. We learn as a people by trying out different ideas and these ideas were not foolish ones. They were worth a try at the time they were developed.
I do find fault with the people who came up with these ideas for one thing. They stated them too dogmatically. You sometimes hear people who believe in the efficient market concept refer to it as the efficient market hypothesis rather than the efficient market theory. That’s the right spirit.
It’s really just a guess. Guesses are fine. But they need to be distinguished from ideas that have been tested and found to possess some substance. That’s not the efficient market theory. There’s never been an iota of evidence to support this one.
Today there is a mountain of evidence showing that it does not check out. They put this one forward too soon. The efficient market concept is a half-baked idea or perhaps a quarter-baked one.
What could the people who developed the Buy-and-Hold strategy have done to have avoided unleashing this terribly uninformed and dangerous model for understanding how stock investing works on the world? I know, teacher, I know! They could have done research. They thought they had.
There was research at the time when Buy-and-Hold was being developed showing that short-term timing doesn’t work. The Buy-and-Holders jumped to the hasty conclusion that, since short-term timing doesn’t work, maybe long-term timing isn’t required either.
Um… No. It doesn’t work like that. To say that, since short-term timing doesn’t work, there is no need to engage in long-term timing is like saying that, since drunk driving is a bad idea, no one should ever get behind the wheel of a car. The one thing does not follow from the other.
The way to determine whether long-term timing works or not is to do research aimed at determining whether valuations affect long-term returns. If the market is efficient, all investors are always rational. If all investors are always rational, mispricing is not possible. So valuations cannot tell you anything.
Valuations Affect Long-Term Returns
Our friend Robert Shiller did the research that the Buy-and-Holders should have done when they were developing their strategy some years after they put it forward. He checked whether valuations affect long-term returns, He found that they do.
The market is not efficient! Investors are not always entirely rational, they are sometimes highly emotional. Mispricing is a real thing. Valuations matter. Irrational exuberance exists. We should all be trying to combat it. We should all be engaging in market timing to the extent needed to keep our risk profile constant over time.
We should all be trying to Stay the Course in a meaningful way! Not by sticking with the same stock allocation at all times. By sticking with the same risk profile at all times. Which requires market timing.
If stock investing risk is variable and not constant, investors who want to maintain the same risk profile in the face of changing stock valuations need to lower their stock allocation when prices rise to crazy high levels. They need to engage in market timing. There is no other way to get the job done.
None of this is complicated. It’s not even too terribly counter-intuitive. It is a little bit. It does seem intuitive to believe that investors would make rational choices. But we know from reading novels and listening to songs and from personal life experiences that the humans are not perfectly rational creatures. They are highly emotional creatures. It’s a good thing that Shiller checked that one out!
Rob’s bio is here.