“In Every Other Market That Exists, Price Discipline Is Key. Price Discipline Is What Makes Markets Work. In the Stock Investing Realm, It Is By Engaging in Market Timing That Investors Practice Price Discipline. So, in Ordinary Circumstances, You Would Think That Everyone Who Works in This Field Would Have Always Urged Investors to Practice Market Timing, That There Never Would Have Been a Single Dissenting Voice.”

Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:

So you only considered one Shiller article from 1981 as the entire body of research over the last 4 decades.

To make sense of what’s happened, you have to consider where the idea that market timing is not requited came from. The intuitive idea would be that market timing is absolutely required. In every other market that exists, price discipline is key. Price discipline is what makes markets work. In the stock investing realm, it is by engaging in market timing that investors practice price discipline. So, in ordinary circumstances, you would think that everyone who works in this field would have always urged investors to practice market timing, that there never would have been a single dissenting voice. But there clearly are many, many dissenting voices. Why?

The answer is — the Efficient Market Theory. The Efficient Market Theory is an academic construct. It has never been proven. That’s what it is called a “theory.” It comes from Adam Smith economics. Adam Smith economics is rooted in the idea that consumers make decisions about purchases through a thinking process in which they engage in the rational pursuit of their self-interest. Eugene Fama (who was awarded a Nobel prize on the same day that Shiller was) took the Rational Man concept and applied it in the stock investing realm. How would the stock market work if investors made decisions about purchases through a thinking process in which they engage in rational pursuit of their self-interest?

If the market were efficient, Buy-and-Hold would be the ideal strategy. If the market were efficient, stocks would always be priced at as close to their proper price as it was possible to determine, based on the information available to investors at the time. Risk would be constant. Investors would not know in advance in which direction prices were going to move. The default best-guess as to what the annual return would be would always be the 6.5 percent real average historical return and there would be a realistic understanding that the odds that the return would be greater than that or less than that would always be the same. Returns would determined by economic developments. Since economic developments cannot be predicted, stock returns could not be predicted. They would play out in the form of a random walk.

The Efficient Market Theory was a real thing. Thousands of smart and good people believed in it. Economists wrote about it and talked about it all the time. They believed in it. So Buy-and-Hold, the academic model for understanding how stock investing works, became the dominant model. Then Shiller blew that world up in 1981, with his “revolutionary” (his word) Nobel-prize-winning research showing that the market is not efficient. If the market is not efficient, then Buy-and-Hold is no more, It does not make sense not to engage in market timing (price discipline). Stock investing risk is not constant, it is variable. The safe withdrawal rate is not one number, it is a number that changes depending on the valuation level that applies on the day the retirement begins.

Humans are not Vulcans. They have emotions. So huge scientific breakthroughs are not always awarded immediate acceptance. There is often a process that the humans need to work through to overcome the cognitive dissonance that interferes with their ability to process a big change in their understanding of a subject of huge importance to them. So not everyone gave up on Buy-and-Hold and became a Valuation-Informed Indexer in 1981 But, going by the science of the thing, that’s what they should have done. The Efficient Market Theory died in 1981. So Buy-and-Hold died in 1981. It should have been replaced by Valuation-Informed Indexing, which is the academic model for understanding how stock investing works that incorporates all the things that we believed about stock investing in 1980 except for the belief that market timing is not required, which was discredited by the research that Shiller published in a peer-reviewed journal in 1981.

Now we know how stock investing works. Good for us. The next step is to get the word out so that we can bring an end to the economic crises that the widespread promotion of strategies that do not call for market timing always bring on sooner or later. Getting the word out should be easy. Lots of people want to know how stock investing works, for obvious reasons. And lots of people want to help those people learn what they need to learn because there’s a lot of personal fulfillment to be obtained by doing so and because there’s a lot of money to be made by doing so.

There’s one thing that stands in our way: You Goons. People do not want to see their loved ones threatened with physical violence. People do not want to see their careers destroyed. People do not want to see their reputations destroyed. People do not want to see any of that garbage. So, to move forward as a society in our understanding of how stock investing works, we need to put you Goons in prison, where you belong, so that the rest of us can enjoy the amazing learning experience that awaits us when we put all the smelly Buy-and-Hold garbage behind us and get about the business of developing the first true research-based model for understanding how stock investing works, Valuation-Informed Indexing.

There has never been any research supporting the idea that market timing is not required. Wade Pfau researched that question very carefully. He spent months on the project. He was astounded. He had heard so many times that market timing is not required (or is not even a good idea!) that he started out believing that there must be research saying so. But no. There is none. The Efficient Market Theory was an ASSUMPTION. No one ever checked on its validity until Shiller did in 1981 and he of course found that the assumption does not stand up to scientific scrutiny. It turns out that investors are humans, not Vulcans. It turns out that stock investing risk is variable, not constant. It turns out that the safe withdrawal rate is a number that varies from 1.6 to 9.0, not a number that is always 4 percent. It turns out that market timing always works and is always 100 percent required. It turns out that Buy-and-Hold is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind.

Does everyone know this and accept this today? No, not by a long shot. About 10 percent of the population knows it and accepts it today. But, once the laws of the United States are being administered in a reasonable way in the investing advice realm, that 10 percent will grow to 20 percent and then to 40 percent and then to 80 percent. We need as a people to insist on reasonable enforcement of the law if we are to tap into the amazing benefits that follow from knowing at last the realities of stock investing. The research goes all one way. There is no legitimate intellectual debate here, just the need to correct an unfortunate misunderstanding that was developed in the 1960s and that was exposed nearly four decades ago. We should be permitting honest discussion of the last 39 years of peer-reviewed research at every internet site and I believe that we will be soon after the onset of the next price crash,when we will all see with our own eyes just how destructive a force the idea that market timing is not required always turns out to be in the long run.

I hope that that helps at least a tiny bit, dear Goon friend.

Scientific-Minded Rob