Set forth below is the text of an e-mail that I sent on January 12, 2010, to Jason Zweig, author of the The Intelligent Investor Column, which runs in The Wall Street Journal.
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 particularly enjoyed your recent article entitled “Inefficient Markets Are Still Hard to Beat”.
I view it as a highly encouraging sign that many writers in this field are now openly acknowledging that the Efficient Market Hypothesis has been discredited. That’s a big step forward. However, I think you (and the other smart people who have adopted this take) are wrong in thinking that Buy-and-Hold Investing can work even in a world in which the market is inefficient in setting prices.
I recently wrote a Google Knol (“Why Buy-and-Hold Investing Can Never Work”) addressing this question. If you have any reactions to the Knol, I would be thrilled to hear them.
The key sentence in your article (in my view) is the one stating that: “Predicting the shifting emotions of tens of millions of people is no easy task.” This claim is both true and false, depending on the time perspective that applies. I agree that it is probably impossible to predict the SHORT-TERM emotion shifts of millions of investors. So short-term timing is out regardless of whether the market is efficient or not. However, predicting LONG-TERM emotion shifts is a very different matter. If the old view of market efficiency is rejected (as it should be), it becomes EASY to predict long-term emotion shifts. It therefore becomes easy to time the market effectively.
The market MUST assign proper values to stocks in the long run. The entire purpose of a market is to do this. So, even if we reject the idea that the market is efficienct immediately, we know that prices ultimately will reflect fair value. This means that, when prices are wildly off the mark, we can count on them returning to fair value within ten years or so. That is, we know the future direction of stock prices. We cannot say precisely when stocks will return to fair-value prices. But we know that the odds of good performance are far, far less when stocks are wildly overpriced (as they were from 1996 through 2008) than they are when stocks are priced fairly or underpriced. Thus, the riskiness of stocks is not a fixed thing but a variable thing. It follows that investors should NOT be sticking with a single stock allocation at all valuation levels. That is, investors should not be following a Buy-and-Hold strategy.
A calculator at my web site (“The Stock-Return Predictor”) performs a regression analysis of the historical stock-return data to reveal to investors the most likely 10-year return for stocks starting from the various possible valuation levels. The calculator shows that most likely 10-year annualized return in 1982 was 15 percent real and the most likely 10-year annualized return in 2000 was a negative 1 percent real. There is no one stock allocation that makes sense in both sets of circumstances. Rational investors must be willing to CHANGE their allocations in response to big price changes in an effort to keep their risk levels roughly constant. It is not the stock allocation re which investors should be “Staying the Course,” it is the risk level (and keeping the risk level constant requires a willingness to change one’s stock allocation in response to big price changes). We have been telling middle-class investors precisely the OPPOSITE of what works for long-term investing for 30 years now!
We CAN predict the shifting emotions of millions of investors. All that we need to do to do so is to look at valuation levels. When prices are at the insane levels that applied from 1996 through 2008, we know that prices are headed down hard in the long term (stock prices must reflect fair value in the long term). As prices drop hard, investor emotions are obviously going to sour (causing even bigger price drops). Thus, we know that long-term investors must be lowering their stock allocations at such times.
It gets better. We can PREVENT overvaluation (and the price crashes that follow from it) simply by making investors aware of this critically important information! Tools like the Return Predictor will make the market self-correcting if they are widely publicized. The Predictor shows investors that the long-term value proposition of stocks is poor when stocks are selling at high prices. Let investors know this and they will naturally lower their stock allocation at such times. This will causes prices to drop. Which means that stocks will be properly valued once again. And stock crashes (and the economic crises that follow from them) will be a thing of the past!
Markets work only when needed information is readily available. Critically important information is not available to most investors at times when Buy-and-Hold Investing is being heavily promoted. Think about it — Buy-and-Hold would not be possible in a world in which most investors possessed a proper understanding of the basics. If we provide investors the information they need to invest effectively, the market will work. The market can set prices properly. But it is up to those who educate the public about how stock investing works to inform people that valuations always affect long-term returns and that Buy-and-Hold is a poor long-term strategy.
If you have any reactions to these thoughts, I would be excited to hear them and would like to report on them at my blog. Thanks for listening in any event and thanks for the good work you do in your columns.