Set forth below is the text of a Guest Blog Entry that I recently submitted to my friend “Pop” at the Pop Economics blog. Pop asked that I take a different focus and on Saturday I submitted a different version. So I thought I would set forth here the language of the initial take. It’s entitled “Valuation-Informed Investing Is Risk-Diminished Investing.”
My name is Rob Bennett. I am the author of a Google Knol entitled “Why Buy-and-Hold Investing Can Never Work” and argue for an investing approach called “Valuation-Informed Indexing” at my web site. This Guest Blog Entry is a response to Pop’s recent blog entry arguing that “Resistance Is Futile: Why Buy-and-Hold Beats Value Investing,” in which he makes the case for staying at the same stock allocation at all valuation levels (Buy-and-Hold) rather than changing your stock allocation in response to big price swings.
Pop argued that: (1) Valuing the market is not an exact science; (2) The market can stay irrational for a long time; and (3) The investor who changes his stock allocation in response to price swings only needs to give in to irrationality one time for his strategy to fail.
I agree completely that valuing the market is not an exact science. I object, though, to the idea that Buy-and-Hold offers some sort of solution to this problem.
The difference between valuation-informed investors and Buy-and-Holders is not really that one ignores value propositions and that one focuses on them. It is impossible for any investor to put money on the table without having in his head some idea of the value proposition being obtained. The difference is that valuation-informed investors are deliberate in their efforts to assess value propositions — they make use of data and tools and logic and so forth. Buy-and-Holders, in contrast, form their value assessments blindly.
The historical data showed that the most likely annualized 10-year return for stocks purchased in January 2000 was a negative 1 percent real. Buy-and-Holders did not consider that reality and elect to invest in stocks regardless because they understand that stock valuation is not an exact science. They fooled themselves into thinking that valuations do not matter and that perhaps stocks could deliver the average long-term return (6.5 percent real) even starting from the insane price levels that applied at those times.
Valuation-informed investors do their best to set their allocations properly, understanding and accepting that today’s tools for doing so are imperfect. Buy-and-Holders check out on the most important part of the investing project; they put their hands over their eyes and their fingers in their ears. That can’t be the right thing to do.
Pop is on the mark again with Point Two, in which he notes that the market can remain irrational for a long time. We were at insane price levels for the entire time-period from January 1996 through September 2008. I went with a 0 percent stock allocation for that entire time-period. I agree that that can be a lonely experience. I agree that one feels pressure to give in to the urge to invest in stocks during such an extended period of overvaluation.
Where I differ with Pop is that I see the answer not in having the small number of us who pay attention to valuations stop doing so but in having the large number who do not start doing so. Consider what would happen if the experts encouraged us to change our allocations in response to big price swings rather than to practice Buy-and-Hold strategies. Each time stocks became dangerously overpriced, large numbers of investors would sell shares. That would bring prices down. The overvaluation problem would always be quickly solved before it got so out of hand as to cause a price crash and an economic crisis.
Stock prices are self-correcting. The market really can be efficient! But only if investors are made aware of the need to keep their risk profiles roughly constant by adjusting their allocations as needed in response to big price swings. When that step is missed, all price discipline is removed from the market. That’s what causes insane overvaluation and the price crashes that follow from it.
Pop again makes a valid point when he says that investors who take valuations into consideration for a time but then break down under pressure can do themselves a lot of harm. I see this as a genuine risk of following a valuation-informed strategy.
Again, though, I see the remedy being encouraging all investors to follow a valuation-informed approach. The reason why many investors felt pressures to follow Buy-and-Hold strategies in recent decades is that those were all they were hearing about on television and in the newspapers and on web sites. What if we changed that? What if valuation-informed strategies were promoted as heavily tomorrow as Buy-and-Hold strategies are being promoted today?
As noted above, the result would be a market in which extreme overvaluation would no longer be a possibility — stock prices would self-correct. Stocks would continue to provide the great returns for which they have become famous. But with only a fraction of the price volatility that we now expect of this asset class. A reduction in price volatility is a reduction in risk. So what we are talking about here is obtaining juicy returns at low risk. That’s investor heaven.
The Buy-and-Holders will object that it’s not possible. “You can’t beat the market!” they will proclaim. I don’t buy it. We are the market. When we say that we cannot beat the market, we are really saying that we are so perfect in our knowledge of how investing works that we cannot beat ourselves — we have already reached perfection in our understanding and no advances are possible.
No! We can “beat” us (the market!) by investing more rationally in the future than we have invested in the past. Valuing stocks properly is the rational way to go. To value stocks properly, we need to pay attention to the prices at which they sell and to adjust our stock allocations accordingly. When most of us start doing that, stocks will be a far less risky asset class and we will all be able to achieve our retirement dreams years sooner.