Set forth below is the text of an e-mail that I sent on January 28, 2010, to James Surowiecki, author of The Wisdom of Crowds.

James:

My name is Rob Bennett. I am the author of the “A Rich Life” blog (http://arichlife.passionsaving.com).

 I recently wrote a Google Knol entited “Why Buy-and-Hold Investing Can Never Work”.

Your book The Wisdom of Crowds played a big part in the development of my thinking on the issues discussed in the Knol. I would like to share with you my take on why the crowd failed to evidence wisdom in the events leading up to the stock crash. I would of course be grateful to hear any reaction from you.

I believe that your idea of crowd intelligence playing a role in setting stock prices properly is of huge importance to the effort to come to a better understanding of how markets work. There is a wonderful line in your article in the Guardian entitled G20 Summit: How the Bandwagon Wrecked the Wisdom of Market Crowds in which you say that “the answer may not be necessarily to use the markets less but rather to do a better job ensuring that…diverse opinions can be easily registered.”

My belief is that there are HUNDREDS of compelling insights to be developed from those few words. I think those words hit on the core problem of the stock market today and suggest the way out of today’s economic crisis.

My take is that it is true that the wisdom of crowds can cause stock market prices to be set properly. However, this can happen ONLY if, as you suggest, diverse opinions can be expressed. In today’s environment (an environment in which Buy-and-Hold is promoted relentlessly), it has become IMPOSSIBLE for diverse opinions to be expressed.

Please consider what the market (which is of course us!) would have to do to keep prices at fair-value levels. It would need to note when stocks had become overvalued or undervalued and then RESPOND to the improper valuation by pushing prices a bit in the opposite direction to the direction in which they had been improperly trending.

Each time stocks became a bit overpriced, investors should be selling stocks as a way of pulling the market price back to fair value. Each time stocks became a bit underpriced, investors should be buying stocks as a way of pulling the market price back to fair value. This is entirely rational behavior as the long-term value proposition of stocks obviously drops when stocks become overvalued and the long-term value proposition obviously increases when stocks become undervalued. Market prices are self-regulating for so long as investors are encouraged to invest rationally.

Now — please consider what has happened in the Buy-and-Hold Era. Buy-and-Hold encourages investors NOT to change their stock allocations in response to valuation changes. Investors are told over and over and over again to stick to the same stock allocation at all times, to Stay the Course. 

Do you see the problem?

The market WANTS to set prices properly. But we have tied the market’s hands by taking away the MECHANISM by which proper pricing is achieved. There are always going to be times when a number of investors become emotional about stocks and engage in behavior that causes prices to go too high. This causes no problem for so long as other investors feel free to do the rational thing and lower their allocations, pulling the overall market price back to what it should be. But none of this good stuff can happen in a world in which millions of dollars are spent promoting Buy-and-Hold Investing, a strategy that urges investors to refuse the rational choice and to act as if no response to mispricing is needed.

The reckless overpromotion of Buy-and-Hold destroyed our market and caused the economic crisis. I believe that we can rebuild the market and our economic system (and repair the damage done to our political system as well) only by openly acknowledging that Buy-and-Hold is the OPPOSITE of what works in long-term investing, that instead of urging investors to stick to the same stock allocation at all times we should be encouraging them to stick to the same risk level at all times (which would require them to lower their stock allocations at times of extensive overvaluation).

I propose the replacement of the Buy-and-Hold Model with its opposite, a model that I call “Rational Investing.” I think this is a big deal. I think that the people who developed the Buy-and-Hold Model were very much on the right track in the work they did but that they made a mistake as to how market efficiency is achieved and that mistake sent thousands of smart and good people down a dark path. Today there is great resistance among many “experts” in this field to acknowledging the errors. The unfortunate consequence is that things keep going down, down, down and the reluctance to take the only steps that could help us take things to a better place grows ever stronger. We need a few thought leaders in this field (like you!) to step forward and call a halt to the defensiveness that has been evidenced in recent years by many Buy-and-Hold advocates.

You hit it on the head when you argue that the expression of diverse views must be permitted for the market to function. I can testify from personal experience that the belief in Buy-and-Hold has become intensely dogmatic, even cult-like, in recent years. In the event that you respond to this e-mail, I will in my next e-mail to you provide links that will let you see for yourself how big the problem has grown as Buy-and-Holders have become increasingly challenged by real-world events that undermine their confidence in their ideas and have responded not by acknowledging possible weaknesses but by denying the possibility of weaknesses and insisting in ever stronger terms that the public discussion of weaknesses be silenced.

That’s enough for one e-mail. Thanks for listening. I wish you well in all your endeavors and thank you for the learning experiences you have provided me as I have pondered the stimulating ideas advanced in your book. If any of what I say here or in the Knol connects with you, please let me know. I would love to see if we can work together to take things to a better place than where they stand today. I believe that if we could get a National Discussion launched on how stock investing really works, we could usher in the Golden Age of Middle-Class Investing. We are now caught in a dark time that could lead to something very positive if only some people could be persuaded to boldly speak out in support of the idea of switching to a different and more promising path forward.

Rob

http://arichlife.passionsaving.com