Home Stocks There Are Five Counterintuitive Aspects to the Valuation-Informed Indexing Model

There Are Five Counterintuitive Aspects to the Valuation-Informed Indexing Model

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The model for understanding how stock investing works that is rooted in Robert Shiller’s research (Valuation-Informed Indexing) is very different from the Buy-and-Hold Model that preceded it and that remains dominant today. If Shiller is right that valuations affect long-term returns, then irrational exuberance is a real thing, stock investing risk is not a constant but a variable and market timing always works and is always required for investors seeking to keep their risk profile constant. I believe that we all should be following the new model.

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Counterintuitive Aspects To Valuation-Informed Indexing

But 90 percent of investors reject it. The biggest reason is that Valuation-Informed Indexing strikes investors who have been steeped in the Buy-and-Hold way of thinking about things as highly counterintuitive. There are five ways in which this is so.

One, the new model posits that investors often act contrary to their self-interest. Investors would be better off if stocks were always priced properly. This would permit them to know the true and lasting value of their stock holdings. Buy-and-Holders assume rationality and that assumption seems reasonable to most investors.

Two, short-term market timing really doesn’t work. Investors find it highly counterintuitive that it is not possible to predict where stock prices will be in a year or two but that it is possible to predict where they will be in ten or fifteen or twenty years.

Three, if Shiller is right, there is a point at which irrational exuberance gets so out of control that super-safe asset classes like Treasury Inflation-Protected Securities (TIPS) and IBonds and certificates of deposit offer higher long-term returns than stocks. That seems to make no sense. Stocks are the more risky asset class. The Buy-and-Hold belief that investors going with the more risky asset class will receive a higher return for doing so strikes most investors as being almost obviously true.

What Causes Changes In Stock Prices

Four, those watching stock prices rise and fall are led to believe that it is economic developments -- not shifts in investor emotion -- causing the price changes. Stock prices usually move in the direction in which one would expect to see them move in response to the most important economic developments of the day. Persuading investors that that is not what is going on -- or at least that that is not the only thing going on -- is a hard business.

Five, stock prices can remain at super-high levels for a very long time. Those expecting to see stock prices fall hard once the CAPE level reaches historically dangerous levels often are surprised to see those prices remain in effect for many years. Most investors do not trust explanations of how the market works that do not prove out for years or even decades.

There are explanations for all of these weird realities. Investors are humans and humans act contrary to their self-interest in all fields of human endeavor outside of the stock investing realm. For market timing to work, stock prices have to return to realistic levels; there is no law that requires this process to be completed within one or two years. It is certainly odd that super-safe asset classes can at times offer better long-term returns than stocks; but this becomes a possibility when most investors rule out market timing, eliminating the only possible brake on irrational exuberance getting wildly out of control. The full reality is that both economic developments and shifts in investor emotion affect prices, with the economic developments often determining the direction in which prices move and the emotion shifts determining the extent of the move. As confusing as it is that stock prices sometimes take a long time to correct, it’s just a reality that investor irrationality is a powerful force that can be slow to dissipate.

The Buy-and-Hold explanation of how stock investing works possesses surface plausibility But, if it were economic developments causing stock price changes, prices should appear in the form of a random walk both in the short term and in the long term. They do not. In the long term, there is a strong correlation between CAPE values and returns. Given that research-demonstrated reality, the Buy-and-Hold Model does not hold water. It is shifts in investor emotion that control where stock prices go.

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