A recent thread at the Motley Fool board reveals both the good and the bad of the “Stocks for the Long Run” investing paradigm.
The thread begins with a Financial Freedom Community member expressing concern re the recent drop in stock prices. He asks: “Is this an opportunity to load up on stocks at a discount?”
Two types of responses follow. One type of response argues that, yes, this is a good time to buy stocks since prices are down. The other type of response argues that, no, this is not a good time to buy stocks because valuations remain high.
Most of today’s investors rely on the Stocks-for-the-Long-Run Investing Paradigm to guide their investing decisions. There are two key premises to that paradigm, one that is supported strongly by a review of the historical stock-return data and one that is completely discredited by a review of the historical stock-return data.
The good premise is the idea that, to be successful, middle-class investors must be long-term buy-and-hold investors. The historical data shows that short-term timing rarely works. It also shows that stocks are a less risky asset class when held for 20 years or longer (because returns become more predictable when stocks are held for longer time-periods).
The bad premise is the idea that stock returns are not predictable. This premise is in conflict with the good premise. If it is so that stocks are a better buy when purchased for the long run, then stock returns must be at least somewhat predictable when stocks are held for the long run. Otherwise, how would it be possible for us to know that stocks are a better buy when purchased for the long run?
The absurd idea that long-term stock returns are entirely unpredictable has left middle-class investors stumbling about in the dark trying to figure out how to respond to a price drop like the one we are experiencing of late. Should they stick with their buy-and-hold strategy and ride out the price drop, or perhaps buy stocks now that they are being sold at “bargain” prices? Or should they look at the historical data which was used to develop the buy-and-hold concept and follow its warning to lower their stock allocations when stocks reach the extreme valuation levels that apply today?
The Motley Fool thread reveals a widespread confusion and disorientation among today’s investors. I recall seeing similar threads in price downturns that took place at earlier times over the past six or seven years. With each downturn, there is less confidence expressed in the comments put forward by those advocating a buy-and-hold strategy. Stocks have not gone down much since we reached the top of the price bubble in January 2000. But they haven’t gone up either. With each year that stocks fail to act “as they are supposed to,” those who have their life savings invested in the self-contradicting Stocks-for-the-Long-Run Investing Paradigm become more unsettled.
One of these days (the historical data does not tell us whether this will happen in a year, in three years, or in five years), some of those who have put themselves at risk by ignoring the message of the historical data will get so nervous that they will switch sides. That will cause further prices drops. The further price drops will cause more “buy-and-hold” investors (it’s not generally possible to practice a buy-and-hold strategy in the real world without taking valuations into account when determining one’s stock allocation) to switch sides. Prices will continue falling (with a number of price jumps mixed in to give confidence to those who will resist the idea of selling until prices drop below the levels that persuade most of their peers to sell) until we work our way back to reasonable price levels, or more likely something a good bit lower than that.
It is painful to me to watch all this play out before my eyes. It shouldn’t be happening. If the big-name investing analysts did their jobs and warned middle-class investors of how great the risks are of investing heavily in stocks at the sorts of price levels that have applied for the past 10 years, the bubble would never have grown so large or lasted so long.
An article recently published at Bloomberg.com quotes a saying often attributed to J.P. Morgan that “in bear markets, stocks return to their rightful owners.” The idea here is that stocks are sold to the middle-class when prices are high and the long-term return potential is limited and then bought back by the wealthy when prices have returned to the more reasonable levels that provide far juicier long-term rewards.
It makes me sick to think that what we are seeing play out before us is a massive transfer of wealth from the middle-class to a relatively small number of already wealthy investors. It is my job, though, to tell it as I see it. I think that that is indeed an important part of the story of our investing discussions of recent years.
Many of the big-name investing analysts have let us down big time. A good number have demonstrated in their writings that they realize how significant an effect valuations have on long-term stock returns. Yet they have failed to put forward clear and direct warnings to middle-class investors to reduce their stock allocations in response to the greater risks that have been associated with stock investing in recent years.
This is an ugly reality. But its one that we must face up to if we are to develop realistic strategies for engaging in long-term buy-and-hold investing. People have put their trust in the big-name investing analysts. And a good number of them have been playing word games, suggesting both that valuations do matter (presumably to provide cover for themselves for when the prevailing winds change direction) and that valuations do not matter (presumably to avoid taking on the wrath referenced by Dallas Morning News Columnist Scott Burns when he observed that the realities of the historical stock-return data are realities “that most people don’t want to hear”).
In the event that stocks perform in the future somewhat in the way in which they have always performed in the past, we are going to see in coming days millions of middle-class investors lose lots of ground in their quests for financial freedom. There have been a lot of not-entirely-serious posts put forward during the first four years of The Great Safe Withdrawal Rate Debate. At root, however, this is a serious discussion. When a middle-class worker loses a large portion of her life savings because of the failure of an investing analyst to tell her what he knows to be so, it’s not a funny thing. It’s a terribly, terribly sad thing and a terribly, terribly shameful thing.
That’s my take, anyway.