There was a comment that a community member made at the Bogleheads Forum a number of years back that made a deep impression on me. He noted that no one has ever walked into a bank and said “I would like three certificates of deposit please” without first stopping to check the interest rate being offered. But people do that when buying stocks all the time. They buy stocks without first looking at the valuation level that applies and thereby gaining some idea what the long-term return on the purchase will be.
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It makes no sense. We buy stocks to obtain a return. We know that the valuation level that applies at the time the purchase is made determines the return that will be obtained. So why don’t we take that into consideration when determining how much of our investment money to direct to stocks?
Market Timing Isn't Evil
Because to do that would be to engage in market timing! That’s why we don’t do it. Market timing is evil. That idea has been drilled into our brains.
Market timing is not evil. Market timing is making use of our reasoning powers to enhance our portfolio performance, just as checking the rate being paid on a certificates of deposit is making use of our reasoning powers to enhance our portfolio performance. Why do we think about these two acts in such different ways?
In a surface sense, the difference is that the interest rate that will be paid on the certificate of deposit is certain while the best that we can do with stocks is to identify a range of long-term returns that are likely to apply given a particular CAPE level that applies at the time of purchase. I don’t see that as much of a distinction. When a certificate of deposit is purchased, the buyer does not know the inflation rate that will apply during the time that he holds the certificate. So he does not know the precise real return that will apply for that investment choice either.
I believe that the real distinction is that we take a businesslike attitude toward the purchases of certificates of deposit. Naturally, we want to know the rate of return that will apply. It is not possible to make an intelligent investment choice without first gaining access to that information.
The puzzle is -- Why do investors not bother to gain access to the information they require to make intelligent purchases of stocks? We like to fool ourselves about how stock investing works. That’s the difference.
Most investors think of the amount of money that they have invested in stocks according to their portfolio statement as the true value of their holdings. Shiller’s research shows that, at times when stocks are overpriced, much of the price of stocks reflects nothing more than irrational exuberance and has no lasting economic significance. For example, stocks are today priced at more than two times their real value. So an investor seeking to identify the true and lasting value of his holdings would need to reduce the number on the portfolio statement by more than 50 percent.
Investors Are Wary Of Rationality
Most of us don’t want to do that. We want to pretend that bull market prices are real. It would be to our benefit to identify our likely long-term return before we made stock purchases. But doing that would shatter the illusion that overpriced stocks are as valuable as fairly priced stocks or underpriced stocks. The illusion has more appeal to us than the information that would permit us to invest in stocks in an intelligent way.
Stock investors are wary of rationality! Rationality is the enemy of illusion and stock investors cherish bull market illusions.
It’s a shocking thing to say. But I think it is the only way to explain the behavior that we see all around us all the time. Today’s CAPE value is higher than the CAPE value that applied just prior to the onset of the Great Depression. It is higher than the CAPE value that applied prior to the 2008 economic crisis. But it doesn’t scare us. So long as we do not do the math that would help us to see how risky a proposition stocks are when they are selling at today’s prices, we can continue to enjoy the feeling that comes from believing that we possess far more in the way of accumulated wealth than we really do possess.
We deliberately keep ourselves in the dark. That’s how we keep the bull market going. If investors were rational, as the Buy-and-Holders assume, this couldn’t happen. There is nothing rational about an investor keeping himself in the dark about an important aspect of the investing project. But we do that. We don’t want to know! And no one can tell us things we do not want to know. Shiller can publish his research and be awarded a Nobel prize and it will not make a difference so long as investors do not care to hear the message.
Are things hopeless?
I don’t think so. We aren’t listening to Shiller today. If we judge the success of Shiller’s work by the extent to which it has kept the CAPE level in check, he has been a failure. We have never before in history seen such a long string of sky-high CAPE values as have we have seen in recent decades. But Shiller’s research does exist. And Shiller’s book was a best-seller. And Shiller really was awarded a Nobel prize. If all we cared about was keeping the bull market going forever, none of those things would be realities.
Stock investors are of two minds re these matters. We really do care about becoming better informed and more rational investors. That’s why we encourage people like Shiller to do what they do. But we resist the message that they aim to impart to us because we really do care about maintaining our belief in the reality of the bull market price levels too. At this time, our desire to keep the bull market going is stronger than our desire to learn what it would take to invest rationally.
I don’t believe that that will always be the case. If Shiller is right, there will be another price crash in the not-too-distant future. I believe that that price crash will shake us up enough to cause us to reevaluate some of our irrational investment practices. I believe that in not too long a time we will begin applying the same rational process that we now apply to the purchase of certificates of deposit to the practice of purchases of stocks as well.
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