The thing that distinguishes Buy-and-Hold (the dominant academic model for understanding how stock investing works) from Valuation-Informed Indexing (the model based on Shiller’s Nobel-prize-winning research showing that the market is not efficient, as was believed when Buy-and-Hold was developed) is that Buy-and-Hold advises against market timing while Valuation-Informed Indexing posits that market timing is essential if investors are to keep their risk profile roughly constant over time and that a widespread failure to engage in market timing will eventually cause the market to collapse. The obvious question is: Whatever causes the Buy-and-Holders to believe that market timing might not work or might be something less than essential?
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Distinguishing Between Short-Term Timing And Long-Term Timing
A big factor was the failure to distinguish short-term timing and long-term timing. Humankind of course did not arrive on Planet Earth with a set of instructions on how stock investing works. The Buy-and-Holders were the first to make the study of stock investing an academic discipline. They did not possess the knowledge that we possess today when they were developing their strategy in the 1960s. We have the benefit of 50 years of research that was simply not available to them.
Their mistake was not to test long-term timing. They did test short-term timing and found (rightly, I believe) that it does not work. The unfortunate logical leap was to conclude from this that no form of market timing works and that no form of market timing is required. Shiller showed that valuations affect long-term returns. Knowing this, it appears looking backwards that it was an absurd idea to think that market timing was not required. In a world in which valuations affect long-term returns, long-term market timing is price discipline, nothing more and nothing less. Price discipline is critical to the functioning of all markets. How could it ever be that market timing would not be required in the stock market?
That’s a fair question. But I do not believe that it would be entirely fair to castigate the Buy-and-Holders for failing to ask themselves that question at the time they were developing their strategy. Shiller’s showing that valuations affect long-term returns was performed by looking at the behavior of the market as a whole (the S&P index). Index funds were not widely available in the 1960s. When the Buy-and-Holders were trying to figure out how stock investing works, the stock investing that they were thinking about was the stock investing that involves the purchase of individual stocks. Market timing works well only with the purchase of index funds. We cannot fault the people who developed an investment strategy in the 1960s for not possessing knowledge of things that were not known in that day.
Valuation-Informed Indexing is the model for understanding stock investing that the Buy-and-Holders would have come up with in the 1960s if index funds had been widely available and if it occurred to them to perform the explorations that Shiller performed years later, when index funds were indeed widely available.
Both models discourage short-term timing. But for very different reasons.
Discouraging Short-Term Timing
Buy-and-Holders discourage short-term timing because of their belief that the market is efficient and sets the proper price for stocks on a daily basis. If the market gets the price right, how could any one investor outsmart it?
Valuation-Informed Indexers discourage short-term timing because of a belief that it is investor emotion that is the primary driver of stock price changes and shifts in investor emotion can only be predicted in the long run. Buy-and-Holders accept the nominal price because they believe it is accurate. Valuation-Informed Indexers believe that the nominal price is often wildly wrong but refrain from short-term timing because they understand that it can take ten years or more for investor mood swings to be be overcome.
Say that we all share a goal of discouraging short-term timing. Which model does a better job of achieving this goal?
I believe that Valuation-Informed Indexing does the better job. Many investors follow a Buy-and-Hold strategy but do not possess a high level of confidence in the strategy. Their common sense tells them that it cannot be a good idea to stick with a high stock allocation when prices travel to very high levels and they are always wondering whether a price crash is coming soon. They are thinking like short-term timers, looking for an exit point from their Buy-and-Hold strategy.
Valuation-Informed Indexers, in contrast, don’t have any confidence in the prices assigned by the market. They do not look for exit points because they do not think that price changes say anything of significance. The only price that matters to a Valuation-Informed Indexer is the nominal price adjusted by the amount of irrational exuberance present in the market at that particular point in time (determined by making reference to the CAPE value that applies at that time).
Buy-and-Hold places a focus on the current market price by teaching that the market assigns prices rationally. It encourages even investors who formally reject short-term timing to think there might be something to it in special circumstances. Valuation-Informed Indexing teaches investors not to trust the prices assigned by the market by treating them as an emotion-based phenomenon rather than as something that possesses economic significance.
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