Buy-and-Hold makes sense.
I don’t like it. I believe that the relentless promotion of the Buy-and-Hold strategy, especially the claim that Buy-and-Hold is research-based, has been a tragic mistake.
I believe that Robert Shiller’s Nobel-prize-winning research finding, that valuations affect long-term returns and that therefore all investors who hope to keep their risk profile constant over time must practice market timing, is legitimate. I like to think of myself as the most severe critic of Buy-and-Hold alive on Planet Earth today.
Q3 2022 hedge fund letters, conferences and more
The Buy-And-Hold Strategy
But Buy-and-Hold makes a great deal of intuitive sense. That’s why it has been so hard to overcome. Investors think it sounds right. Investors think it is supported by common sense. Investors view it as a prudent approach.
It is anything but, in my view. If valuations affect long-term returns, stock investing risk is not a constant but a variable. If risk is greater at times of high valuations than at times of low valuations, then investors who want to maintain a constant risk profile have no choice but to engage in market timing.
Buy-and-Holders disdain market timing. By-and-Hold is the opposite of what works, according to the research. But it sounds good. It sounds like it should work.
Shiller has described the intellectual leap from the finding that short-term price changes are unpredictable (University of Chicago Economics Professor Eugene Fama showed this in research published in the 1960s) to the Buy-and-Hold belief that the market sets prices properly as “one of the most remarkable errors in the history of economics.” That’s the story. It is very hard to argue against the idea that market timing is not required because doing so is like fighting a ghost.
There’s never been any evidence that market timing isn’t required and common sense says that it must be. In every market that has ever existed, price discipline is the thing that keeps the market functional. And, in the stock market, market timing is the means by which investors exercise price discipline.
Take away that tool, and you make the market dysfunctional, Dysfunctional markets eventually crash. Market timing is the thing that keeps stock prices reasonable. The Buy-and-Holders made a terrible mistake in urging that the thing that keeps the market functioning properly be done away with.
Changes In The CAPE Value
The rub is that it can take a long time for the market dysfunction created when many investors fail to engage in market timing to evidence itself in a noticeable way. The CAPE value rises. That’s the sign that prices are out of kilter and that trouble is on the horizon.
But prices can remain high for many years before they produce a price crash and an economic crisis. The negative consequences that follow from a widespread failure to engage in market timing are often long deferred.
Until the price crash hits, most investors remain unconcerned. Most aren’t even aware of changes in the CAPE value. Most of those who are shrug them off. So long as the market doesn’t crash, the CAPE value is just a number. A high CAPE value is a flashing red light. But a red light is not itself a terrifying event, it is only a warning that one is coming. Most investors drive merrily though the red light without a care.
Because everything seems okay until the price crash arrives. The portfolio statements arrive each month and the numbers are good. Try telling an investor who sees good numbers on his portfolio statement that there is something wrong with the market. It’s those numbers that are real, the irrational exuberance stuff is just talk. Irrational exuberance is hard to pin down. If you can’t touch it, why worry about it?
I like to make the comparison to alcohol addiction. An alcohol addiction is a very real thing. If you have ever sat in a 12-step meeting and heard the stories of promising lives destroyed, you know that that is so. But an alcohol addiction doesn’t make any sense, does it? Why would someone destroy his own life by drinking to excess? Once he saw that he was destroying his life, wouldn’t he just stop?
It is fortunate that we are more advanced in our understanding of drinking problems than we are in our understanding of Buy-and-Hold investment strategies. If the Buy-and-Holders were in charge of the 12-step meetings, they would tell the attendees not to worry about the harm that drinking is doing to their lives because an alcohol addiction is not a rational thing and thus cannot possibly exist.
The humans are fully capable of irrational behavior and of doing great harm to themselves by indulging in it. The Buy-and-Holders are wrong. Irrational exuberance is a real thing and we all should be doing everything in our power to rein it in.
Rob’s bio is here.
