How Our Ideas on Stock Investing Got on the Wrong Track

I say controversial things about stock investing.

Most people believe that following a Buy-and-Hold strategy is the way to go. I do not. Buy-and-Hold is rooted in the research of University of Chicago Economics Professor Eugene Fama. I advocate Valuation-Informed Indexing, the investing strategy rooted in the research of Yale Economics Professor Robert Shiller. Shiller’s ideas represent a “revolutionary” (Shiller’s word) departure from the conventional wisdom of today.

The big change is that Buy-and-Holders think they are engaging in a neutral act when they rebalance their portfolios. Vanguard Founder John Bogle says that investors should aim to “Stay the Course.” Staying at the same stock allocation is staying the course, in the eyes of the Buy-and-Holders.

Valuation-Informed Indexers see it as dangerous move for an investor to stay at the same stock allocation at all times. We believe that valuations affects long-term returns. So stocks are far more risky and offer far lower returns when priced high than they do when they are priced low. It is our view that investors MUST change their stock allocations in response to big valuation shifts to have any hope of staying the course in a meaningful way. Investors who rebalance rather than change their stock allocations are permitting their risk profiles to get wildly out of whack by doing so.

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It is my view that all of the research in this field supports the Valuation-Informed Indexers and that none of it supports the Buy-and-Holders. I do not mean for that claim to be taken as an insult. I view the Buy-and-Holders as good and smart people. My take is that the reason why the Buy-and-Holders believe that the research says something very different from what it really does say is that they made a mistake in the early days that caused their fundamental beliefs about how stock investing works to get seriously off track.

To understand what happened, you need to appreciate the history.

The first point that needs to be made is that the Buy-and-Holders were pioneers. It is common practice today for investment analysts to root their claims in research and data. That was not the case in the days before the publication of A Random Walk Down Wall Street (the book that popularized the Buy-and-Hold concept). In the old days, most investing advice consisted of subjective impressions. We all owe the Buy-and-Holders a debt of gratitude for taking investment analysis out of the dark ages and imposing the accountability that comes with turning the study of investing into a sort of science.

There is a reason why few people long to be pioneers. Pioneering is dangerous. Pioneers often return to camp with arrows piercing all sorts of sensitive body parts.

The Buy-and-Holders got important things wrong because those who go first often get important things wrong. We didn’t know it all back in the early 1970s. Research on all of the important questions had not yet been completed in the days when Buy-and-Hold was being developed. So the Buy-and-Holders were forced to take some guesses, and the research that has been done in the 40 years since has shown some of those guesses to have been dangerously off the proper path.

The big mistake was the finding of the Buy-and-Holders that timing doesn’t work.

That one is partly true. I rank the partial truth as the second most important insight in the history of investing analysis. It really is so that short-term timing doesn’t work and it was an important advance for the Buy-and-Holders to discover this.

Unfortunately, the research showing that short-term timing never works was done at a time when we did not know how important it is to distinguish short-term timing from long-term timing. Shiller taught us the importance of that distinction with research he published in 1981. At the time Buy-and-Hold was being developed, the finding that short-term timing doesn’t work was interpreted as a finding that timing doesn’t work, period. That’s why most of today’s investment advisors fail to stress the importance of long-term timing, which ALWAYS works and which reduce the risk of stock investing by 80 percent while dramatically increasing long-term returns.

Is Shiller’s work a rejection of Fama’s work?

Most Buy-and-Holders see it that way. Most Buy-and-Holders become defensive when the 30 years of research confirming Shiller’s findings is mentioned. I think that’s unfortunate. My view is that Valuation-Informed Indexing represents a combination of the critical insights of the Buy-and-Holders and the critical correction added by Shiller. I think of Valuation-Informed Indexing as a new approach to Buy-and-Hold Investing, a sort of Buy-and-Hold 2.0.

The Buy-and-Holders made a mistake. That mistake has cost a lot of people a lot of money. That mistake has caused a lot of confusion about how stock investing works both among experts and among regular investors. That mistake has brought on an economic crisis.

Still, the full reality is that our understanding of all areas of life endeavor is achieved in building-block style. We learned a great deal when the Buy-and-Holders showed us that short-term timing doesn’t work. Shiller would probably never have achieved his advances had the Buy-and-Holders not laid the foundation for them with their own breakthroughs.

The Buy-and-Holders think that acknowledging their mistake will cause them to lose “credit” for explaining how stock investing works. I don’t think that’s right. I think that that acknowledgement of the mistake will permit us to take the genuine insights of the Buy-and-Holders to places we have never been able to take them before. I believe that we will someday look back at the day when the Buy-and-Holders acknowledge their error as one of the most important and exciting days in the history of the core Buy-and-Hold project — to learn the truth about how stock investing works.

 

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Comments

  1. says

    Great article. I’ve found “buy and kinda hold” to work when it’s combined with long term timing, which is also called buy low and sell high. That (buy low and sell high) sounds almost too obvious, but if you look at how people bought in 2006 and 2007, you can see it isn’t nearly as obvious as it sounds.

    I was fortunate to be be in a position where I could do some major purchasing in early 2009 when the market was close to its bottom. That opportunity will probably not present itself for another 7-10 years, no matter what the perma-bears love to say. That’s long term timing, and it works for anyone who will listen.

    Dogmatic buy and hold doesn’t pass the smell test. If you see Yahoo going down the tubes, what are you going to be? Dogmatic or pragmatic? You got to know when to fold ‘em. It isn’t every week or even every month, but it’s not never, either. As someone pointed out, Warren Buffett has sold out of more positions than he held on to.

  2. Rob Bennett says

    Thanks for your kind words, William.

    Valuation-Informed Indexing IS Buy Low/Sell High, but with a twist. In the old days, people tried to practice Buy Low/Sell High with individual stocks. That’s hard. No matter how much you research any one stock, you could miss a point and get it wrong. That never happens with an index. With indexes, Buy Low/Sell High has ALWAYS worked so long as you are willing to wait 10 years for the payoff.

    The difference is the difference between asking your best friend who he is going to vote for and taking a poll of 1 million voters. One person can decide how to vote for all sorts of quirky reasons and one company can do well or poorly for all sorts of quirky reasons. But a poll of 1 million voters can really help you predict the election and looking at the valuation level of a broad index can really help you predict where stock prices will be 10 years from now.

    The creation of index funds changed the investing project in a fundamental way and people are only now beginning to appreciate how much it did so.

    Take care.

    Rob

  3. says

    I agree with the value of indexes. In fact, Warren Buffett says if you’re not into individual companies, it’s the only other kind of investing he recommends. But I like the quirkiness of individual stocks. Call me greedy, but if I can get twice the market gain with a 2 Beta stock, that’s what I want. It’s not only the financial gain, but the thrill of the chase. Hunter-gatherer man 21st century style! :)

  4. dei trey der says

    Isn’t the decsion to NOT buy individual stocks (using indexing instead) just as ‘bad’ as buying and holding stocks, versus trying to find some value-based buy/sell trigger points to trade?

    It seems to me that both methods (buy and hold, as well as indexing) are each attempts to ‘ignore the noise’ of having to trade based on fundamental analysis, or on prevailing market conditions, and instead, let the ‘strength of averages’ do the heavy lifting, albeit at the potential expense of some beta…

    I am just very curious as to why Bennett finds one to be unpardonable sin in his eyes, and yet he finds the other to just be a ho-hum option-play for each investor to decide on.

    That just does not seem internally consistent to me.

    If, ad Bennett proposes, one “should” market time, then it seems to me that one also must buy and sell individual stocks if you hope to remain logically consistent with yourself as an ‘active’ investor, minding your affairs based on available market information.

  5. Rob Bennett says

    That’s a super comment, dei trey der. I don’t agree with the point you are making. But you are making a very intelligent observation which I think gets to the heart of things.

    Picking stocks adds to risk. If you are good at it, there can be a payoff. But most of us are not good at it. And there is no need to take on this added risk to earn a very good return. So my take is that most investors should not be taking on this added risk.

    Ignoring price does not reduce risk, it ADDS to risk. I agree with Bogle’s view that we should all be trying to “Stay the Course.” To do that, we need to aim to stay at the same risk level. Stocks are far riskier at times of high prices. So you MUST be willing to change your stock allocation to have any hope whatsoever of Staying the Course in a meaningful way.

    The reason that the Buy-and-Holders don’t see it this way is that they believe the market is efficient. If the market were efficient, everything they say would be so. I give them that. I just don’t believe that the market is today anything close to efficient. Shiller’s research shows that the market is wildly INefficient. It is only by changing our stock allocations in appropriate ways that we can bring the market closer to efficiency.

    That was a super question. I am most grateful to you for putting it forward regardless of whether we end up in agreement or not.

    Rob

  6. dei trey der says

    Timing stocks adds to risk. If you are good at it, there can be a payoff. But most of us are not good at it. And there is no need to take on this added risk to earn a very good return. So my take is that most investors should not be taking on this added risk.

  7. Rob Bennett says

    Timing stocks adds to risk.

    Does it?

    That’s the entire question, DTD. The Buy-and-Holders believe that timing adds risk. That’s why they avoid it. The Valuation-Informed Indexers believe that staying at the same allocation at all times adds risk. We believe that stocks are more risky when they are priced high and that the only way to get our risk profile back to where we intended it to be is to lower that darned stock allocation.

    Who’s right?

    That’s what all our internet discussions of how stock investing works are aimed at finding out.

    Please take care, my new friend.

    Rob

  8. dei trey der says

    Rob, based on what I have seen of your ideas, I think that any discussion of ‘how stock investing works’ that involves you would be about like calling my six year old in for a consult regarding a prospective periodontal procedure.

    She would be enthusiastic, but not particularly helpful.

  9. Rob Bennett says

    Thanks much for sharing your thoughts, DTR.

    I think!

    Rob

  10. Marek says

    very good article, i’m enjoy it wp

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