All Studies That Support Buy-and-Hold Are Analytically Invalid

Beyond Buy-and-Hold #59

There?s nothing I say about investing that more upsets Buy-and-Holders than my claim that Buy-and-Hold is a ?Get Rich Quick? scheme. But I keep right on doing it. Why?

Because I believe it really is so and because I don?t believe that any of us can become effective long-term investors until we come to understand why it is so. The purpose of this article is to make the case, preferably in a way that offends my Buy-and-Hold friends to the smallest extent possible given the circumstances that apply.

To make my case, I?d like to refer you to an article about Valuation-Informed Indexing written by Jacob, author of the My Personal Finance Journey blog. Jacob is a 100 percent straight shooter. He has been a friend to me, even at times when he was taking a chance of getting other friends of his annoyed with him for evidencing his friendship to me. I point this out to let you know that none of the words below are intended to serve as any sort of criticism of Jacob whatsoever.

Jacob?s article does something highly constructive. People can from now until doomsday put forward their opinions about the merits or lack thereof of Valuation-Informed Indexing and Buy-and-Hold and not necessarily move the ball forward too much. Jacob did something more helpful. He took the time to look at the data and to arrange what he found in such a manner that we could all reach useful conclusions about what it says. Helpful stuff.

And he is perfectly fair in how he states things. He says that he believes that Valuation-Informed Indexing offers promise since it displays much less risk (lower standard deviation). But he also says that the Valuation Informed Indexing strategy needs to be refined before he is ready to adopt it as his investing strategy for his personal investments. He essentially concludes that the matter is an open question at this point.

My strong sense is that many people are thinking about this in the way that Jacob is — viewing VII as just a way to make allocation choices. It represents a much more fundamental change. It changes how we assign a value to our portfolios and how we think about what causes price changes.

Now —

There is a sense in which this is so. We humans are not ever permitted to know Truth perfectly. So it could be that everything I have ever said about investing is wrong. In all likelihood I would be the last to recognize my mistakes. That?s a live possibility and Jacob?s article performs a service by making us aware of it.

That said, Jacob?s way of looking at the data from my perspective shows him to be caught up in Get Rich Quick thinking.

Please note that I said that this is so only from my perspective. I do not for three seconds believe that Jacob is aware that he is caught up in Get RIch Quick thinking or wants to be caught up in Get Rich Quick thinking. One of the unfortunate aspects of Get Rich Quick thinking is that those caught up in it are never aware that they are caught up in it at the time they are caught up in it.

It is possible that it is Rob Bennett who is caught up in Get RIch Quick thinking, not Jacob. But of course from my perspective it seems to be Jacob who is the one caught in the trap. So, to speak honestly to you about my investing beliefs, I need to say it that way.

What?s the sign of Get RIch Quick thinking that I see?

It?s that Jacob concludes that Valuation-Informed Indexing has not performed better than Buy-and-Hold in recent years by comparing the current-day values of a Buy-and-Hold portfolio and a Valuation-Informed Indexing portfolio using nominal stock market prices.

From Jacob?s perspective, there is nothing weird or odd or strange about this. This is how most investing studies are set up today. All Jacob did here was follow the operating procedure that has become common in the field.

My gripe is —

The Valuation-Informed Indexing model rejects that way of doing things!

Valuation-Informed Indexers believe that valuations matter. If valuations matter, you cannot identify the true value of a portfolio without making an adjustment for valuations. Say that an investor retires with a portfolio nominally priced at $1,000,000 at a time when the P/E10 value is 30 (two times fair value). The Valuation-Informed Indexer views that portfolio as possessing a lasting value of only $500,000 (half of the temporary nominal value). Many Buy-and-Holders have been thinking since 1996 (when valuations first reached dangerous levels) that Buy-and-Hold has been producing good results. But the good results were largely a function of overpricing. When portfolio values are adjusted for the effect of overpricing (as they always should be, according to Valuation-Informed Indexers), the gains achieved during a bull market are less impressive.

This is true of every study that has been done under the Buy-and-Hold model. All of the studies really say what the Buy-and-Holders say they say. But they are all set up in the way that Jacob?s test was set up, that is, without valuation adjustments. In the eyes of Valuation-Informed Indexers, every study that has ever been performed under the Buy-and-Hold model gets all the numbers wildly wrong. We believe that valuations are the most important factor. Any study that ignores the most important factor must get the numbers wildly wrong.

The obvious question is — Why do the Buy-and-Holders not agree that valuation adjustments are needed?

I think it is because they want to be able to count the gains they got excited about during the bull years as real. When I insist that they make adjustments, I am as much as saying that those gains were phony from the first day and never should have been given any credence. That comes as a shock to those who have been counting on those gains to help finance their retirements.

Shocking or not, that?s what I believe. So that?s what I say I believe when I write about stock investing on the internet.

Jacob and all the others do not believe what I believe. So they obviously need to tell a different story. They can add to the discussions only by saying what they sincerely believe and so they must continue to do so and all Valuation-Informed Indexers must show them the respect and affection and gratitude they earn by doing so.

But it works both ways. Rob Bennett and the other Valuation-Informed Indexers must be granted the respect and affection they have earned by posting honestly as well. We don?t say this to be mean. We say it because we are trying to help others understand better how stock investing works and because we believe that the emotion that causes many investors not to want to factor in valuations is an important part of the story.

Rob Bennett often writes about the dangers of Passive Investing at his web site. Rob?s bio is here.

( Photo from Flickr by Helico )

3 Responses to All Studies That Support Buy-and-Hold Are Analytically Invalid

  1. I look forward to reading everyone’s thoughts on improvements that can be made to the methodology that goes in to these types of analyses and also possible refinements to the VII strategy! Good post!

  2. I told Jacob in an e-mail that I can think of no other person on the internet who has been as fair in his comments about Valuation-Informed Indexing as he has been.

    My personal belief is that we will be making refinements in VII for many years to come. Just as we have been making refinements in Buy-and-Hold for many years now. We never reach a point at which we know all there is to know about any subject. So refinements are always needed (and always a good thing — it is by learning what refinements are needed that we make life on Planet Earth better over time).

    I am known as a critic of Buy-and-Hold. My personal view is that a better way to say it is that I am the biggest advocate of a new approach to Buy-and-Hold alive on Planet Earth today. The reason I have made such an effort to distinguish Valuation-Informed Indexing from Buy-and-Hold is that a number of Buy-and-Holders want nothing to do with VII. There’s a widespread view that we are better off just going with what we knew from the research done before 1981 and ignoring the findings of the last three decades. Not this boy! I think that take is flat-out insane.

    I am working on a book on investing. I plan to call it Investing for Humans. But one of my early titles was The New Buy-and-Hold. My heart is very much with the Buy-and-Holders. I just don’t like living in the past.

    Thanks much for stopping by, Jacob. I hope that over time we are able to persuade more and more Buy-and-Holders to adopt the positive and constructive and life-affirming approach that you have always evidenced in these discussions.


  3. I look forward to reading everyone?s thoughts on improvements that can be made to the methodology that goes in to these types of analyses

    Re the methodology question, my take is that those who do studies of stock investing questions should always disclose what sort of methodology they are using. Buy-and-Hold studies are rooted in University of Chicago Economics Professor Eugene Fama’s Efficient Market Hypothesis and thus do not contain adjustments for the effect of valuations. Valuation-Informed Indexing studies are rooted in Yale Economics Professor Robert Shiller’s research showing that valuations affect long-term returns and this always contain valuation adjustments. The two types of studies obviously always produce wildly different findings.

    The important thing is that the readers of the studies be made aware that they are not reading scientific truths but tentative findings depending on a belief in one of the two models. The Old School safe withdrawal rate studies don’t reveal metaphysical truth re SWRs, they just tell us what those who believe in the Buy-and-Hold model believe the SWR to be. The New School SWR studies tell us what the SWR is for those who believe in the Shiller model.

    All of the disputes that have raged for over nine years now are the result of the failure of researchers and investing experts to note that their studies are valid only if the premises on which the methodologies of those studies were built are valid. I believe in the Shiller model. So I obviously cannot say that I believe that the Old School studies are valid. It would be dishonest of me to do that. Each community member has to say what he or she sincerely believes to be the case. This should not be controversial!

    Buy-and-Hold is rooted in a belief in the Efficient Market Hypothesis (Shiller had not yet published his research at the time Buy-and-Hold was developed). Buy-and-Hold is not Truth with a capital “T.” It is just an hypothesis that many smart people have over the years come to believe is true. All research done in this field should specify the model in which it is rooted. It is imperative that the investors making use of investing studies know that there is another model that produces research generating very, very different findings.


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