Stocks are wonderful.
The average return is 6.5 percent real. That tops the return provided from just about anything else. Stocks are the ticket to financial freedom for middle-class workers.
Stocks are awful.
Talk to people who have lived through a long-running secular bear market and you may never again put a penny into stocks. Stock prices fell by 89 percent in the years following the great 1929 crash. And valuations had not gone nearly as high then as they did in the years leading to today’s economic crisis. It may take us years or even decades to recover from what reckless stock investing has done to our economy in recent years.
Stocks are wonderful. Stocks are awful. Can both things be so?
They are both so. Because of one factor — the volatility of stock prices. It’s stock volatility that makes stock investing so scary and confusing. Do away with stock volatility, and stocks would become the best asset class ever imagined.
I think it’s possible. I think stock volatility is optional.
Have you ever thought about what causes stock volatility? It’s the humans. The humans get excited about stocks and bid prices up to insanely high levels. Then, when prices fall (as they must when they are driven so high as to be unsustainable), the humans panic and send prices down to equally insane low levels. If we could teach the humans to invest less emotionally, we could make stock volatility a thing of the past.
Is there anything we could do to make stock investing less emotional and thereby reduce volatility? I believe that there is a lot that we could do.
Most investing experts urge us follow a Buy-and-Hold strategy. That means staying at the same stock allocation at all price levels. I believe that that is a terrible idea. Stocks obviously do not perform as well starting from high prices as they do starting from low or moderate prices. So why go with the same stock allocation at all price levels? I think that we should buy stocks in the way that we buy everything else — we should stock up (go with a higher allocation) when prices are low and stock down (go with a lower allocation) when prices are high.
Warren Buffett recommends just this. He says that we should be greedy when others are fearful and fearful when others are greedy. The historical record shows that Buffett is right. I have checked the record to see how much of an edge is gained by investors who are willing to defy the Buy-and-Hold mantra and invest in a valuation-informed way. The benefits are amazing. The data shows that the typical middle-class investor could retire five years sooner just by making this one change in his asset allocation strategy.
So why don’t we all do it?
It goes against human nature.
It’s easy to buy stocks when they are overpriced. Stocks become overpriced because they are popular. When stocks become popular, stock investing feels safe. It’s not. It’s when stocks are popular (and thus overpriced) that they are most dangerous. But our emotions tell us just the opposite message of the message that would be told by logic if only if we would listen to it.
There’s another problem. Most of the people who we think of as investing “experts” are tied in some way to The Stock-Selling Industry. Their job is to persuade us to buy stocks regardlless of price. Guess who promotes Buy-and-Hold most avidly? Yup — it’s the people who make millions getting us to let our guard down about overpriced stocks.
Say that doctors gave dietary advice in the manner in which investing experts give asset allocation advice. They would note that most of us are emotionally inclined to want to eat six pieces of chocolate cake every day, and in an effort to get us to like them would assure us that eating six pieces of chocolate cake every day is the only way to go for the long-term eater. We would die many years sooner but we would calling our doctors Saint Jim and Saint Susan in the way that many today refer to John Bogle as “Saint Jack.”
Good investing advice isn’t investing advice that makes us feel good at the time, but investing advice that provides the best returns in the long term. That’s not Buy-and-Hold. It’s valuation-informed investing strategies that work best in the long term. We should be looking for investing advisors willing to tell us why we need to resist the urge to follow Buy-and-Hold strategies, not for the ones who tell us that it is fine to give in to our emotional urges knowing that it is we who pay the price for such short-term thinking.
Another lesson that we need to learn is that price changes don’t matter.
That’s the lesson that the historical data teaches. Price increases aren’t really a good thing. And price drops aren’t really a bad thing. Price changes don’t really matter.
What matters? The productivity of the U.S. economy. It is the productivity of the U.S. economy that finances that 6.5 percent average return. Volatility is the result of our emotional reactions to various news developments and our expectations about what those news developments are going to mean for stock prices.
If we come to accept that price changes don’t matter, we will stop bothering to try to figure out the effect of news developments on stock returns. We will stop selling in reaction to what we view as bad news and we will stop buying in reaction to what we view as good news. Volatility will be gone. We will just have to get used to seeing that 6.5 percent gain year in and year out.
I’m joking. A world without stock volatility would be a wonderful world indeed. It would be a world in which we enjoyed all the good of stock investing and none of the bad.
You may say that I’m a dreamer. But, if you open your mind to a new way of thinking about stock investing, I won’t be the only one.