A community member named “James” wrote in an e-mail:
“I just listened to your podcast on Buy-and-Hold Cannot Work. I was referred to it by a friend with whom I have recently been discussing the same concepts.
“What you don’t mention in this podcast is the primary basis for the Stay-the-Course concept. As I understand it, the idea is that: The market is smarter than any one individual and automatically prices value effects into itself. Ergo, it’s safe to be passive!
“Quite obviously, this is not correct, but I would be interested in how you refute it.”
Set forth below is my response:
Thanks for your note. You pose an interesting question.
The idea that the market gets the price right is called the Efficient Market Theory. As you note, this is the intellectual framework for the Passive Investing concept. The Efficient Market Theory was at one time believed to be true. However, there has been much evidence accumulating in recent decades that it does not accurately describe how markets work.
Please take a look at these three blog entries:
The Efficient Market Theory is rooted in a premise that investors are all rational actors seeking to maximize their returns. If this were so, the claim that is made — that the market price is close to being right — would indeed follow. The problem is that the premise does not stand up to scrutiny — we are NOT rational actors.
Humans have both a rational side and an emotional side. At times of massive overvaluation, human investors (that’s pretty much all of them!) are highly emotional. They WANT valuations not to matter and are inclined to ignore the wealth of evidence showing that they do. Those acting emotionally are NOT seeking to maximize their returns. They are more interested in being proven right in their investing beliefs than they are in accumulating wealth. The collective decisions of irrational investors do not work to set the market price properly.
Think of an alcoholic. An alcoholic is not rational. He sacrifices his family, his job and his health for the temporary pleasures of drink. At times of massive overvaluation, investors are essentially Stock Drunk. The drunk denies that he has a problem and Passive Investors deny that it is possible for the market price to be wrong. But these denials are themselves part of the problem — vehement denial is common among both drunks and passive investors.
The very fact that the Efficient Market Theory (and the Passive Investing model that goes with it) is so popular is evidence of the problem. Such theories always become popular at times of high valuations. The popularity of such theories fades as prices return to reasonable levels (as they must if the market is to continue to function). The aim of these theories is not to explain how markets work in the real world, but to rationalize an emotional desire to invest heavily in stocks at a time when the long-term value proposition attached to doing so is poor.
I hope that helps a bit. Welcome to the Financial Freedom Community!