Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
“The best thing for investors is for the price always to be at fair value. That allows for an annual price gain of 6.5 percent real, which is of course super.”
The problem is if there was a 6.5% real/no volatility asset available to buy, so many people would want to buy it that the price would be driven up.
Imagine there was an investor named Rob, he loves stocks but doesn’t want to over pay for them so he is at a 0% stock allocation.
Then one day, as if by magic, stocks priced to deliver 6.5% real, priced at “fair value” and poised to grow uniformly so as to always remain at “fair value” are available.
Rob gathers up his money, pulls up at the stock market, spies a suitable person who already owns some stock and says “Hey you, I’d like to buy some of those fine looking stocks”
The investor, lets call him Evidence Based Investing, takes a look at Rob and says “Are you f*ing kidding me? I own these 6.5% real/no volatility stocks and you want me to sell them to you? Not only will I not sell them you but if anymore are available I would buy them too. In fact I would out bid you. I don’t need 6.5% real, I am happy with 6.0% real and there are probably many investors who would accept lower returns and pay more. Sell them to you? You’re crazy”
You see, that is the fundamental problem with your whole magical high return low risk future. If it ever happened it would attract so many new buyers that the price would rocket and returns fall. It simply can’t happen.
I am grateful to you for making an intelligent point, Evidence. The kind of question that you are raising here is the sort of thing that needs to be the subject of a national debate. I wish that more people were here to read your words. And I would like people to read my response too. But not because I want to “win” the debate. I want people to think these things over and to come at them from multiple perspectives. These are important matters. And they are puzzling matters in many respects. People should be trying to figure these things out.
The premise of all of your words in this comment is that investing is a rational enterprise. The entire Buy-and-Hold Model is built on that premise. Shiller has CHALLENGED that premise. That’s the difference in point of view. If it really is so that investing is a rational enterprise, Buy-and-Hold is the ideal strategy. I grant you that. But Shiller has showed with the examination of historical return data that investing is NOT a rational enterprise, that it is a highly EMOTIONAL enterprise. And I think he is on to something. So it is not persuasive to me to say “this just doesn’t make rational sense.” The entire history of the market does not make rational sense. If investing were a rational enterprise, prices would fall in the pattern of a random walk. They do not. There is a strong correlation between today’s CAPE level and the price that will apply 10 years from today. That shouldn’t be. And yet it is so.
Do we have to get angry at each other because we do not agree on this point? I am not angry at you. I like it that you are here. You keep me honest. You add points that I would not be able to make because I do not share your perspective. What I want is to feel free to keep YOU honest. And to keep other Buy-and-Holders honest. Not because I don’t like you. Because I DO like you. Because I want you to at least be exposed to any questions about Buy-and-Hold that you need to be exposed to to know the full story. Hearing those questions can make you experience doubts. Hearing them and wrestling with them can also strengthen your confidence over time. I want us both to say what we believe and either persuade the other over time or make the other more confident in his position over time because it is a position that has been tested and that has survived the test.
Those are my thoughts, in any event.
If we give people the information that they need to obtain higher returns from stocks while taking on less risk, the safer asset classes will have to offer higher returns. I give you that one. But I see that as a good thing. I would like to see the returns on Certificates of Deposit increase.
My point, though, is that you cannot assume rationality. In 2000, TIPS were paying a risk-free 4 percent real and the likely 10-year return on stocks was a negative 1 percent real. Explain that one. You seem to think that irrational things simply cannot happen. But that happened. I don’t even recall too many people speaking up about it at the time.
We should all want more rationality. I want as much rationality as possible. But I am not willing to assume it. We have to WORK for rationality. Giving people the information they need to earn higher returns on stocks while taking on less risk is helping them to invest more rationally. It’s a good thing. We shouldn’t be worried that, if we make stock investing better for everyone, that some other asset class will do worse. The people offering the other asset classes will figure out how to keep up. Markets adjust to changed circumstances. Opening up the entire internet to honest posting on the last 38 years of peer-reviewed research in this field would just be one more changed circumstances re which the markets for all of the various asset classes would need to adjust.
What you really are highlighting with your comment is that stocks are an amazing asset class. Under the reasoning you use in your comment, we could conclude that even the current situation is impossible, that stocks are just too darn good. Stocks really are an amazing asset class. That’s just the way it is. And I don’t think we should worry that it is impossible that stocks could ever be a better asset class than they are today. If the research shows that we can make stocks a more appealing asset class than they are today, we should go for it.
And please remember that we would never see huge bull markets in a world in which we were free to post honestly re the last 38 years of peer-reviewed research in this field. Stock prices increased by 126 percent from 1996 through 1999. Something like that could never happen in a world in which investors were able to educate themselves about how poor a long-term investment stocks become when the price gets too high. So there would be negatives for stocks in a post-Shiller world.
However, the positives for stocks would be much greater than the negatives. Risk would be dramatically reduced. And returns would be far more stable. And ultimately, returns would be higher because economic growth would be increased in a world in which these insane price swings did not cause so many business failures. Rationality is a plus. One could argue that it is a “free lunch.” We just have to accept that rationality cannot be assumed, we have to work to secure it.
There’s no reason why you have to take on huge amounts of risk to get a return of 6.5 percent real from stocks. The 6.5 percent real return comes from the productivity of the underlying companies. Why shouldn’t investors be able to tap into those gains? They are putting up the money that produces them. That’s a perfectly legitimate arrangement. Most of the risk of stock investing is voluntary in the days since publication of Shiller’s amazing, Nobel-prize-winning research.
That’s my sincere take, in any event.
Rob
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