Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
“Which strategy do you think it is that gets the numbers right?”
I think the markets for bonds, cars, apples, houses, and everything else is rational. Assets are priced based on their value to people, and that value may fluctuate.
When the price of apples change, I don’t ascribe that to grocery store emotion. Not do I look for patterns in the past 140 years of apple prices and assume they must repeat. I assume there’s a rational, economic reason for the price change. Maybe more people are eating fruit. Maybe there was a drought. What am I missing?
I agreed with most of what you said in that comment but not quite with 100 percent of what you said, Anonymous.
I agree when you say that “assets are priced based on their value to people and that value may fluctuate.” I don’t agree when you say that “the markets for bonds, cars, apples, houses and everything else is rational.” Prices definitely fluctuate. But not all price changes are rooted in rational causes. Say that you like beanie babies. And the price of a beanie baby is $3. You make it a practice to buy one every month and you are happy with that purchase. But then the price starts heading upward. The price goes to $6. You enjoy your beanie baby habit. So you continue buying at $6. But then the price goes to $12 and then $24 and then $48 and then $96. Should you just say “oh, well, I know that the price for beanie babies must be rational, so I am just going to keep buying”? Should you say: “If the price for a beanie baby goes to $500, I’ll pay $500. I like buying beanie babies. The people who make a living selling beanie babies have said that beanie babies are a great buy at any possible price. So I am just going to ignore price and continue buying”?
For markets to remain rational, there must be some rationality applied to purchasing decisions. I think that you are right that prices are GENERALLY set by a rational process. So, if weather conditions cause apples to become more scarce, the price goes up and the market thereby addresses the scarcity problem. Or, if apples become plentiful, prices go down. I think that what is going on here is that Buy-and-Holders are looking at these rational processes that really do exist and are becoming impressed by them and jumping to the hasty conclusion that prices are ALWAYS rational. That’s the thing that is not so. Prices CAN be rational and markets serve a great purpose in facilitating the process by which rationality is reflected in prices. But prices can also go nuts for emotional reasons. In those cases, great harm can be done unless steps are taken that permit rationality to reassert itself.
You need to go a step beyond just saying “oh, prices are usually rational, there’s nothing to worry about here.” You need to ask yourself WHY prices are usually rational. How is it that the prices of apples and other things are set properly and effectively? It happens through the exchange of information. The price of the apple is marked at the grocery store. Consumers make a mental calculation as to whether apples are “worth it” or not and then decide whether to make a purchase or not. Prices that are set improperly will not stand because the market will punish the owners of stores that set arbitrary prices. The people buying apples act in their own self-interest. They purchase apples when it makes sense to do so and they refrain from purchasing apples when it does not make sense to do so.
For people to act in their self-interest, they need access to information about the purchase they are making. In January 2000, the most likely 10-year annualized return for stocks was a negative 1 percent real. The guaranteed return for TIPS was 4 percent real. Investors who were acting in their self-interest would have lowered their stock allocation and increased their TIPS allocation. Millions of transactions of that nature would have caused the return on TIPS to drop and the return on stocks to increase. So eventually prices would again have been rational and the market would have been working effectively.
But we had a Ban on Honest Posting in effect that kept the market from working as we want it to work. Magazines could have made a lot of money by telling their readers how they could retire so much sooner by taking the simple step of moving a portion of their money from the poor-value-proposition stock class to the strong-value-proposition TIPS class. But the Buy-and-Holders had become insanely emotional by this time (as evidenced in the P/E10 level that caused that negative 1 percent long-term return!). The Buy-and-Holders were going to punish any magazine that published articles helping out the millions of middle-class people seeking to choose what asset class to invest in to finance their retirements.
There were little newsletters that published that sort of information. Shiller published his book in March 2000. But the big magazines stayed away from telling people how they could increase their return by 5 full percentage points real per year for 10 years running. Buy-and-Holders would have been threatening to destroy the careers of any editors who permitted articles helping their readers to run in their publications. Most editors picked up on the vibes, which were not exactly well hidden, and did not what would have helped their readers but what spared their own careers. They ran headlines screaming “Buy-and-Hold!” They pushed more of the Get Rich Quick garbage that caused the problem in the first place rather than the how-to-act-in-your-own-self-interest stuff that we all need if we are to invest effectively and if the market is to price things rationally.
Markets are usually rational. You could say that markets want to be rational. But rationality must never be ASSUMED. For rationality to apply, market participants need access to the information they require to act in their self-interest. Take that information away and you take rationality away. The Buy-and-Holders have taken rationality out of the stock market by ASSUMING that it will always be present and using that assumption to justify engaging in outrageous behavior aimed at insuring that investors do not have access to the information they need to invest effectively. Investors need to know the true safe withdrawal rate at each valuation level. This is essential information. We have seen thousands of our fellow community members express a desire to have access to this information. But the Buy-and-Holders have shut down all efforts to transmit such information widely. So the market has become more and more irrational as the Buy-and-Hold Era has continued.
If it were not for the Ban on Honest Posting, stock market prices would be set rationally. But that’s not the world we live in. We live in a world of death threats and demands for unjustified board bannings and tens of thousands of acts of defamation and demands that academic researchers who do honest work on safe withdrawal rates be fired from their jobs. We live in a world in which Buy-and-Hold has become the dominant investing strategy. We do not live in a rational world in the investing realm today. And so the market is not able to serve its purpose of setting prices rationally at this point in time.
I don’t look for patterns in the past 140 years of stock prices for the purpose of making predictions as to whether they will repeat or not. I look for patterns to determine HOW THE STOCK MARKET WORKS. There are two schools of thought in the academic literature in this field re that question. One is rooted in a premise that the market is efficient. One is rooted in a premise that investor emotion is the dominant factor in the setting of stock prices. The two schools lead to very different strategic recommendations.
If you believe that the market is efficient, Buy-and-Hold is the ideal strategy. If you believe that investor emotion is the dominant factor, Buy-and-Hold is the most dangerous strategy ever concocted by the human mind. I look to the 145 years of historical return data to figure out which school is the correct one. If the market were efficient, we should see prices falling in the pattern of a random walk both in the short term and in the long term. If investor emotion is the dominant factor, we should be seeing a random walk only in the short term and a strong, repeating hill-and-valley pattern in the long run. What we see is a random walk in the short term and a strong, repeating hill-and-valley pattern in the long run. So I subscribe to the Valuation-Informed Indexing school of academic thought.
That’s what I think you are missing, Anonymous. I think you are ASSUMING rationality rather than checking to see if it is really there. I think that’s a dangerous way to proceed. It is investors who impose rationality on the market through their millions of daily investing choices. We keep the emotion of the market to a minimum by acting rationally over and over and over again. To do that, we need to check things out. We need to look at research. We need to talk things over calmly with others looking at research. We need to quantify things. We need to challenge conventional wisdom. We need to put investing experts on the hot seat to determine whether their ideas really hold water or not. We need to question, question, question, question and question some more.
The Buy-and-Holders don’t do that. The Buy-and-Holders ASSUME. They HATE questioning. They want everyone to invest blindly based on research that was published over 50 years ago and to ignore the 36 years of research discrediting those earlier findings. That’s not me. I question. I don’t always get them right. I don’t claim to. But I do aim to always question. That’s my “crime” in the eyes of the Buy-and-Holders.
I was once one of them because I heard some rhetoric in which the Buy-and-Holders CLAIMED to be open to the scientific process for discovering truth and that’s what I believe in and so I went that way. I stopped believing in Buy-and-Hold on the evening (August 27, 2002) when Greaney put forward his first death threat and 200 of my fellow community members endorsed it (50 endorsed a post condemning the death threats). Death threats are not part of the scientific process. Most Buy-and-Holders no longer possess confidence that their ideas re how stock investing works can prevail if they are exposed to the questioning that is a critical part of the scientific process. So I am no longer a Buy-and-Holder. I believe in Valuation-Informed Indexing, the investing strategy for those who still believe in the things that the Buy-and-Holders once believed in but no longer do now that Shiller’s “revolutionary” (his word) research has been awarded a Nobel prize in Economics.
Rationality is not automatic. Rationality has to be provided by the humans. Humans need access to information, preferably in the form of peer-reviewed research, to behave rationally. The Ban on Honest Posting, which has been enforced so brutally by our Buy-and-Hold friends for 15 years running now, is killing us all.
My sincere take.