Yesterday’s blog entry reported on an e-mail sent to me by Academic Researcher Wade Pfau on March 10, 2011. I sent my response later the same day. The text appears below.
Thanks for letting me know that you came through the earthquake okay. I of course feel for and will pray for all the people affected.
The question is: WHY isn’t Buy-and-Hold mean-variance efficient?
The logic of Buy-and-Hold is rock-solid. It SHOULD work. Think about what you have shown. You have shown that there are circumstances in which returns are higher in Treasury bills than they are in stocks. That is INSANE. That cannot be. It IS. But it CANNOT be. Both things are so.
Say that your paper were published. And say that all of the web sites and books and magazines reported on this. Would this not change investor behavior? All investors want to achieve good results. No one is going to elect to remain in stocks when Treasury bills are offering a better return once they know that this is so.
That means that there are not going to be any more bull markets after your research (and lots more research like it that will follow in its wake) is published. And no more bull markets means no more bear markets. Volatility is OPTIONAL. If we let people know how stock investing works, stock price volatility comes to an end.
This is of course wonderful news. Our problem is that it is TOO wonderful. Things that are too wonderful upset the applecart in a big way. You are causing trouble for everyone who has ever advocated Buy-and-Hold. And that includes a lot of your peers!
What has happened historically is that in the 1960s for the first time the analysis of how stock investing works became an academic pursuit. This changed things in a fundamental way. Until then it has just been people taking guesses and people trying to sell junk. Starting in the 1960s it became possible to achieve real and lasting advances in our understanding of the realities.
Buy-and-Hold was popularized by the publication of “A Random Walk Down Wall Street” in 1974. From 1974 to 2011 is 37 years. That seems like a lot to us. But in the grand scheme of things that’s the wink of an eye. All that has happened in the grand scheme of things is that some perfectly smart people happened to make a mistake and they have gained so much fame and wealth as a result of that mistake that they have become emotionally reluctant to acknowledge it. The history train is moving in our direction and it cannot be stopped. Buy-and-Hold will die by the same power by which it came to life — analysis of the historical return data.
This is an either-or, Wade. There is no middle ground. You either believe that the market is efficient (that all factors affecting price are considered at all times) or you believe that valuations affect long-term returns. If you believe that valuations affect long-term returns, you believe that there is at least one important factor not being taken into consideration when prices are set — Valuations. If valuations are being considered, both overvaluation and undervaluation are logical impossibilities. The people who buy stocks refuse to pay insanely high prices for anything else they buy. If they begin to refuse to do this when buying stocks, we can never again see another bull market (each price
increase would bring on sales and the sales would lower prices).
It might help to put this in an economic context. What your findings are really challenging is Adam Smith economics (at least as it has been formulated in the past). Adam Smith economics ASSUMES rationality on the part of economic players. Adam Smith economics is Rational Man economics. You are saying that investors are irrational. You are saying that millions of investors elected to buy stocks at a time when the most likely annualized 10-year return was a negative 1 percent real and when an investment class with a government guaranty attached (TIPS) was offering a return of 4 percent real. It is not possible to believe both that investors are capable of doing such a thing and that investors always make rational choices. Humans are capable of huge amounts of irrationality. Adam Smith economics is not a complete explanation of how the world works.
Everyone has known that Adam Smith economics is not a complete explanation for many, many years. But people have accepted the model on the grounds that it is the best we can do and that it is better than nothing. But Fama took a fateful step when he applied Adam Smith economics to the study of stock investing. With stock investing, it is possible to quantify the extent to which the reality deviates from the theory. P/E10 does this. P/E10 tells us the extent to which humans deviate from rationality. It reduces investor emotion TO A NUMBER.
You’ve brought up the question of whether there is anything new here or not. The idea that valuations affect returns is not new. It is the QUANTIFICATION of this that is new. Our practice in the past has been to overlook the problem of investor irrationality because we don’t feel comfortable dealing with it. Once we quantify it and see that investor irrationality has been the primary cause of each of the four economic crises we have seen since 1900, we are not able to rationalize anymore. That nonsense came to an end (intellectually, not practically) when we came up with this idea of subjecting stock investing to formal, scientific analysis. We have put one of out favorite rationalizations to death.
Learning is good. This is all good. There is zero downside to having humankind rise to a new level of understanding of how stock investing works that permits us to put an end to bull markets and bear markets and economic crises. But that
doesn’t mean that everybody is going to greet the change with open arms. People were suspicious about the harnessing of electricity. People were suspicious about the idea of flying in airplanes. People were suspicious about the personal computer. There is a lot of resistance to the idea of reporting the numbers used in stock analysis accurately. But accurate reporting of the numbers will come (unless as a society we give up on science altogether — I view that as an exceedingly far-fetched possibility).
So there are going to be fights. But we know in advance which side is going to win in the end. The battle is not primarily an intellectual battle. All of the evidence is on one side, so there is nothing intellectually to fight about. The battle is a POLITICAL battle. I can tell you as someone who has been doing this for nine years that the only thing that has ever helped was the stock crash and the economic crisis. There has been a HUGE softening of resistance over the past two years. The next crash is going to bring ANOTHER huge softening. And then we are off to the races.
The risk here is that the next crash may also put is into the Second Great Depression. All predictions about the future are out at that point.
But if we are heading into a Game Over situation, nothing much matters anyway. So I don’t view that as a real downside in a practical sense. If we are able to avoid the Second Great Depression, we are headed to the biggest advance in our understanding of how stock investing works ever experienced and I believe that that advance will translate into an era of huge economic growth.
I apologize for putting forward so many words. But I want to offer you an explanation of this rejection and this is the only sane explanation that I am able to offer. People don’t want to accept that this is an either-or. People want to be able to say that both Fama and Shiller are right. It’s okay to say that they are both smart and good people and that they are both pioneers and all that sort of thing. It is not okay to say that they are both right. If Fama is right, Shiller is wrong. If Shiller is right, Fama is wrong.
If Shiller is right, Buy-and-Hold is not a generally good but slightly flawed strategy. If Shiller is right, Buy-and-Hold is the purest and most dangerous Get Rich Quick strategy ever concocted by the human mind (not by intent — but still).
I really think that the logic chain that I am putting forward here holds, Wade. You are going to be rejected lots of times because of the exceedingly strange nature of the controversy you are addressing. But your work will ultimately be accepted. And when it is accepted, it will not be accepted as a nice step forward. It will be accepted as the most important piece of investment research yet published or it will not be accepted at all (there are many who do not permit themselves to acknowledge even to themselves the reasons for their rejection of the research but on some level of consciousness they appreciate the implications of your findings and cannot permit them to be publicized until they have come emotionally to terms with them).
The good news is that we are one stock crash away from Buy-and-Hold tumbling to the ground. Everyone alive wants to know how to invest effectively, Once Buy-and-Hold tumbles to the ground, there is nothing anymore to stop us all from mining hundreds and hundreds of very powerful and enriching insights into how stock investing really works.
It is not written in stone that economics must always be known as the Dismal Science. It’s been the Dismal Science for many years because for many years we have not known many important things about how economics works. As we move from ignorance to knowledge, economics becomes less and less dismal. It’s all up to us — the humans!