Valuation-Informed Indexing #175 — Shiller Places Too Much Emphasis on “Bubbles”

I’ve posted Entry #175 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Shiller Places Too Much Emphasis on “Bubbles.”

Juicy Excerpt: It’s a mistake to focus on bubbles because there really is nothing special about bubbles. Shiller’s breakthrough was not discovering bubbles. It was discovering that it is investor emotions rather than economic and political developments that set stock prices. This reality applies during bubbles. But it also applies at times when stocks are reasonably priced and at times when stocks are insanely underpriced. It is ALWAYS investor emotion that is setting stock prices.

The benefit of looking at how prices are set rather than at bubbles is that it is something we can test far more effectively. Bubbles are a rare phenomenon. So it is hard to prove to skeptics that what you say about them is so. Even if your predictions prove out, it might be another 30 or 40 years before there is another bubble and you will be able to get a second bubble prediction right. Fama noted that he is not impressed by anything less than 10 correct predictions and Shiller noted that he will not live long enough to get 10 bubble predictions right.

Shiller WILL live long enough to get 10 valuation predictions right.

Comments

  1. Iron Man says

    Rob,

    Do you think you will ever see one of your predictions come true in your lifetime? Your batting average hasn’t been that great so far.

  2. Rob says

    Every substantive-based prediction has come true, Iron. I reported on the errors in the Old School safe-withdrawal rate studies 10 years before the Wall Street Journal reported on them. I predicted the economic crisis long before it became a reality. I told people to lock in those 4 percent real returns that were once available in TIPS and IBonds before they disappeared. I reported that stocks offered a strong long-term value proposition when prices dropped to moderate levels in early 2009 and those who invested in stocks at that time have seen the decision pay off. And on and on and on.

    You are right, though, that my batting average has been ATROCIOUS on the process side. I expected to get beaten up by you Goons for two or three days when I worked up the courage to post honestly on safe withdrawal rates back on the morning of May 13, 2002. I was a wee bit off re that one. And, if you had asked me back at that time what the odds were that people like Scott Burns and Jack Bogle and the owners of the Motley Fool site and the Morningstar site and the Index Universe site would tolerate the behavior we have seen from you Goons, I would have put the odds at one-million to one.

    What we are seeing is that, when it comes to the stock market, emotion dominates everything.

    We learned something amazing back in 1981. The Buy-and-Holders achieved some major advances. They missed out on one big issue (price discipline), the issue that is more important than all the other issues put together. We ALL benefit by fixing that mistake. But so far as a society we have just not been able to work up the courage to do it. I never imagined that it would be this difficult.

    To understand why this is so, it helps to look at how negative emotions can cause people to act irrationally on non-investing contexts. It is the same humans who destroy themselves in non-investing contexts who destroy their portfolios by failing to exercise price discipline in the investing context. To understand how investing works, we need to understand how the humans who buy and sell stocks work.

    Say that there is a man who has a great deal to offer to the world who becomes an alcoholic. Over time, he loses everything — his wife, his children, his house, his money, his job, his friends, his self-respect, perhaps even his freedom (if he ends up in jail). Sad stuff. Now say that he hits bottom and gets to work solving the drinking problem. You look at him five years later and he has it all together again. He is able to build a wonderful new life.

    He always had it in him. He just couldn’t do what he needed to do because admitting that he was an alcoholic hurts his feelings of false pride. So for years he engaged in choices that seemed to everyone who knew him to be 100 percent irrational. The actions WERE irrational in an objective sense. But in the mind of the poor fellow suffering from alcoholism they made perfect sense. He was hurting so much that he just had to protect his feelings of false pride no matter how much destruction they caused. In fact, the more destruction they caused, the more defensive he became re the root problem!

    That’s where we stand re Buy-and-Hold today, Iron. It is killing us. It is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind. It caused the economic crisis. It threatens to put us in the Second Great Depression if we don’t sober up soon. But the idea of coming clean re the bad investing advice we have been giving for decades now scares us all to death.

    It means rewriting all the textbooks. It means fixing all the calculators. It means seeing wealthy and powerful people reduced to saying the words “I” and “Was” and “Wrong.” It means thousands and thousands of lawsuits to recover financial damages. In a few extreme cases (like yours, Iron Man!), it means prison sentences. It’s a hard, hard, hard, hard business.

    I underestimated how hard this would be. You got me re that one, Iron.

    I also vastly underestimated how wonderful the results would be on the substantive side. If you had told me on the morning of May 13, 2002, that my working up the courage to post honestly on safe withdrawal rates would a number of years later lead to me becoming the co-author of peer-reviewed research showing millions of middle-class investors how to reduce the risk of stock investing by 70 percent, I would have said you were loco. But here we are.

    You’re feeling great pain, Iron. I don’t say different. Millions and millions of others are feeling great pain. It is horrible for me to contemplate that it is likely going to take another price crash for us to open the internet to honest posting. But we are in a Catch-22. We cannot open the internet to honest posting without causing millions to for a time experience even greater pain than they feel today. And we cannot relieve the pain of these millions of people in a permanent sense without opening the internet to honest posting. It’s a mess!

    It’s bigger than me, Iron. I will continue working this as hard as I can every day of my life. It’s my patriotic duty to do so. But I am more or less resigned to the apparent reality that it is going to take another price crash for us to pull together to bury Buy-and-Hold 30 feet in the ground, where it can do no further harm to humans and other living things. I am not Superman. I am some guy whose only claim to expertise in this field is that he figured out how to get his words posted to the internet. I’ll do what I can do. I can do no more and I can do no less.

    The fact that it has been so hard to get the word out re the importance of price discipline to the millions who very much need to hear it does not tell us that taking investor emotions into consideration when setting one’s stock allocation is unimportant. It tells us that it is 500 times more important than I realized on the morning of May 13, 2002. The reason why we are able today to reduce the risk of stock investing by 70 percent is that our knowledge of how stock investing works has been so primitive that huge advances remain possible. Investor emotion is BY FAR the most important factor in any investing analysis. Our mistaken decision during the Buy-and-Hold years to give zero consideration to the most important factor has caused more human misery than any other mistake ever made in the history of personal finance. By a factor of 500.

    I will soldier on, despite my horrible batting average, my long-term Goon friend.

    With love in my heart for the Wall Street Con Men and the Lindauerheads and the Greaney Goons as well as the millions of middle-class people that comprise the group that truly drives my efforts.

    I naturally wish you the best of luck in all your future life endeavors.

    Rob

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