Set forth below is the text of an e-mail that I sent on January 11, 2010, to Justin Fox, the author of The Myth of the Rational Market:
My name is Rob Bennett. I write the “A Rich Life” blog (http://arichlife.passionsaving.com). I am a big fan of your work and recently wrote a Google Knol (“Why Buy-and-Hold Investing Can Never Work”) which briefly refers to you. After finishing it, I thought that I should write you to let you know about it and to share my thoughts with you about one issue on which we do not agree (your belief that Buy-and-Hold makes sense even if the market is not efficient).
Here is a link to the Knol:
In the event that you have any reactions to it, I would be thrilled to hear them.
I do not agree with you that there is no way for investors to reliably beat the market even in the event that the market is not efficient. I believe that the confusion on this point stems from the history of the learning process we have gone through on these issues. There is not one possible explanation for why short-term timing does no work. There are two. The academics jumped to the conclusion that the explanation is that the market is setting the price of stocks properly. Another perfectly satisfactory explanation is that the market is entirely NON-efficient in the short term and BECOMES efficient only over time (after the passage of perhaps 10 years of time or so). If this is the explanation (I believe it is), Buy-and-Hold is the worst of all possible strategies and it IS possible for informed investors to beat the market reliably.
If market prices are set primarily by emotion in the short-term but are efficient in the long term, stock prices are always in the process of moving in the direction of fair value. This means that there is great danger in following a Buy-and-Hold strategy at times of extreme overvaluation (such as we saw for the entire time-period from 1996 through 2008). Here is a link to a calculator at my web site (“The Stock-Return Predictor”) that uses a regression analysis of the historical stock-return data to reveal the most likely 10-year return starting from all possible valuation levels:
Please look at the most likely annualized 10-year return that applied in 1982 — 15 percent real. Now consider the most likely annualized 10-year return that applied in 2000 — a negative 1 percent real. An 80 percent stock allocation makes sense when the likely long-term return is 15 percent. A 20 percent stock allocation makes sense when the likely long-term return is a negative 1 percent. There is no one stock allocation that makes sense in both sets of circumstances. Buy-and-Hold can never work for the long-term investor. The risk profile for stocks changes with changes in the valuation level. An investor following a Buy-and-Hold strategy is letting his risk level change dramatically over time. This does not make sense.
Other calculators at the site (“The Investor’s Scenario Surfer” and “The Investment Strategy Tester”) permit investors to determine how much of an edge they gain by being willing to adjust their stock allocations in response to big changes in valuation levels (I called this strategy “Valuation-Informed Indexing”). The short answer is that investors doing this can realistically expect to be able to retire five years sooner than Buy-and-Holders. It often takes several years for Valuation-Informed Indexers to gain an edge. But the odds are extremely strong (about 90 percent) that eventually they will. Once they do, the magic of compounding kicks in to make their long-term portfolio values much, much higher than what could be achieved with a Buy-and-Hold strategy.
The beauty of indexing is that it permits the investor to reap the market return without having to study the prospects of the underlying companies. All that an investor needs to know to invest effectively is essentially “cooked in” to the market price, making it unnecessary for investors to even follow economic developments There is one big exception to this general rule, however. Overvaluation and undervaluation are never “cooked in” to the market price By definition, the market cannot price in the extent to which it has failed to properly price itself. For indexing to work, investors must incorporate an adjustment for the effect of valuations to determine a true market price and then invest in the improperly priced market to the extent appropriate given the extent of the overvaluation or undervaluation that applies (a lower stock allocation than normal is appropriate at times of overvaluation and a higher stock allocation than normal is appropriate at times of undervaluation).
Imagine what would happen tools like The Stock-Return Predictor were widely publicized. The Predictor teaches investors an amazing lesson — each price change greater than the price change justified by the economic realities (that’s been a price increase of 6.5 percent real per year throughout the history of the U.S. market) has both a positive and a negative element to it. Overvaluation increases an investor’s portfolio size, which is a positive, but it also diminishes the likely long-term return, which is a negative. The net effect is a wash. The rational response by investors to overvaluation is to lower their stock allocations (because the likely long-term return has dropped). A lowering of stock allocations brings valuations back down to reasonable levels. The market price is self-correcting!
The question we should be asking ourselves is — Why did the market price not self-correct from 1996 through 2008? I think that the answer is that most investors are not able to gain access to the information they need to invest rationally. I have written about these ideas at numerous discussion boards and blogs over the past eight years and have consistently experienced intensely abusive posting by large numbers of Buy-and-Holders. Trying to believe that price does not matter (an idea at odds with common sense) makes investors insanely defensive. The result is that an antipathy to learning the realities of stock investing develops. Investors go to great efforts NOT to know how to invest rationally and effectively. At some point, the problem grows so great that the market is forced to correct itself through a crash.
If investors were encouraged at every step of the way NOT to follow Buy-and-Hold strategies but instead to keep their risk levels roughly constant (by adjusting their stock allocations in response to big price swings), this emotionalism would never become a problem, stocks would never become overvalued (the market would self-correct so that the P/E10 level would always remain somewhere near fair value), and we would eliminate the risk of stock crashes (and the economic crises that follow from them).
I would love to hear any reactions if you care to share any.
In any event, I wish you the best of luck in your future endeavors. Perhaps we will meet up on a blog at some point and be able to engage in some back and forth re these matters. Thanks much for listening to these thoughts.