How Our Stock Addiction Grew Gradually Worse Over Time

Beyond Buy-and-Hold #68

By Rob Bennett

One of my critics makes a great point in a recent Bogleheads Forum discussion of the Valuation-Informed Indexing concept. A poster going by the name ?nisiprius? says: ?I just don?t believe that a few simple rules based on numbers that are easily available to everyone will substantially improve your risk-adjusted returns.?

I say that the typical middle-class investor could retire five to ten years sooner if he were willing to switch from Buy-and-Hold to Valuation-Informed Indexing. I say that the heavy promotion of Buy-and-Hold was the primary cause of the economic crisis. I say that we would eliminate 80 percent of the risk of stock investing by letting investors know about the 30 years of academic research supporting this approach.

Yet the only difference between Buy-and-Hold and Valuation-Informed Indexing is that Buy-and-Holders choose a single stock-allocation percentage that makes sense for them at all times while Valuation-Informed Indexers change their stock allocations in response to big valuation shifts. Could this one strategic change really make such a big difference? That?s more than a little hard to believe, isn?t it?

It?s hard to believe.

The power of addiction

But let me tell you a story about my coffee addiction. I drink ten cups of coffee each day. I wish I didn?t. If I am busy doing something in the morning and don?t get to coffee for a few hours, I get a massive headache. I am certain that this coffee addiction is not good for my health. Until I went to college, I didn?t drink any coffee whatsoever. I sometimes wonder how it is that I got on this road that led over time to a situation where I am drinking ten cups of coffee every day.

It wasn?t a conscious choice. There was never a thought in my head that I really should increase my coffee consumption from one cup per day to ten cups per day.

It happened gradually and without me taking much notice of it. Once I had a habit of drinking one cup per day, going to two cups per day did not seem like a big deal. Once I had a habit of drinking two cups per day, going to three cups per day did not seem like a big deal. You get the idea.

This is how it works with stock valuations. Stocks were priced insanely low in 1982. Then valuations went up a bit. But it didn?t matter because prices were so low. Then valuations went up a bit more. But it still didn?t matter because prices were at fair value. Then valuations went up a bit more. But it still didn?t matter because stocks offer a strong value proposition even when they are selling at prices a bit above fair value.

Then there came a day when stocks were priced at three times fair value. At that point, the most likely annualized 10-year return on stocks was a negative 1 percent real. IBonds were at the time offering a guaranteed return of 4 percent real. So middle-class investors who stuck with stocks lost 5 percentage points of return for 10 years running. Do the math and you see that Buy-and-Holders ended up losing 50 percent of their accumulated wealth of a lifetime as a result of their addiction to Buy-and-Hold strategies.

Buy-and-Hold and the economic crisis

We lost so much wealth in so short a time-period that we are now scared to death to spend money. So tens of thousands of companies are going out of business and millions of workers are being laid off. Lots of people are losing confidence in a political system that permits such massive wealth destruction to take place. We are likely within a few years of going into the Second Great Depression.

No one knew this was going to happen when we first began thinking it might be a cool idea to follow Buy-and-Hold strategies any more than I knew that someday I would be suffering from a terrible coffee addiction on the day I drank my first cup of coffee following my Political Science 101 class back at old Temple University. These things catch up with you over time.

Some people think it can never change. Buy-and-Hold investing strategies have been causing stock crashes and economic crises ever since the first stock market opened for business. So some people think we can never do better. Some people think we are doomed to repeating the fatal mistake of ignoring valuations over and over and over again.

I don?t buy it.

Change may be hard, but it?s never impossible

It?s true, though, that it is awfully difficult to persuade people that valuations make a huge difference after they have been ignoring them for so many years. If we are going to become effective investors, we are going to need to start watching valuations even at times when we are not living through an economic crisis. We need to make watching valuations as important a priority as we make looking at the price of things we buy before we put money down on the table. If our free market system is to survive, we need to begin buying stocks in the same way we buy all other goods and services in this Consumer Wonderland we have created for ourselves.

How is it that one number — the P/E10 value — matters so much?

People say that the P/E10 value reveals the level of overvaluation present in the stock market at any given time. That?s so. But there?s a different way of looking at it. Stocks can never become overpriced so long as investors are acting rationally. The sensible thing to do would be to price stocks properly. So what P/E10 is really telling us is how emotional investors are being at any given point in time.

P/E10 protects us from ourselves!

If we made it a practice to use P/E10 to set our stock allocations even when prices had not yet reached insanely dangerous levels, prices could never get to insanely dangerous levels. Using P/E10 takes the emotion out of stock investing.

It?s one thing we are talking about here. It really is hard to accept that making one change could make such a huge difference. But the one thing we are changing is whether investors act emotionally or not. Change that and you really do change the nature of the stock investing game in a fundamental way.

Rob Bennett has written extensively on what causes stock price changes. His bio is here.


Related Posts:

This is the Best Time in History to be a Stock Investor
The Second Depression Cometh
Am I Crazy For Being Out of the Stock Market for 14 Years?
Most Stock Investors Are Gambling With Their Retirement Money
Nine Reasons Why Stock Valuations Make a BIG Difference in the Long Run
Risk-Free Stock Investing?

( Photo from Flickr by Helico )

6 Responses to How Our Stock Addiction Grew Gradually Worse Over Time

  1. Hi Rob–I have two thoughts on why buy-and-hold remains so popular despite the events that have rocked the market over the past 12 years:

    1) Many, perhaps most, stock market investors believe that the financial crisis is behind us and we’re on our way to a stronger economy with still higher stock prices, and

    2) Near zero interest rates and a collapsed real estate market are leaving stocks as the only investment game in town.

    The stock markets have always been hyper focused on interest rates, and with those rates now at historic lows, optimism continues to support the markets. I think that a spike in rates–which I think is coming but it’s just a question of when–will undo most of that confidence. The market and its participants are ignoring the massive amount of debt in the world in favor of the rosey picture being painted by super low rates. When reality reasserts itself the fallout will be spectacular, and that’s when valuations will matter.

    Until then valuation informed indexing will probably remain little more than an interesting theory, but not one strong enough to warrant abandoning buy-and-hold. The artificial rate environment we’re in is causing an alternate realty because few are looking past it to what comes next.

  2. I stay away from stocks now. I have been burned too many more times than I have celebrated.

  3. David:

    I hope you will someday reconsider. My personal view is that you are better off out of stocks today. But to swear off stocks altogether puts you in circumstances in which you will likely delay your retirement a good number of years.

    The biggest financial problem that the middle-class investor has is that The Stock-Selling Industry today controls what we can hear about stock investing. They push Get Rich Quick to the fullest because of the financial benefits they obtain from doing so. But the internet could change all that. If we could persuade some of the big blog sites to open up their blogs to honest and informed discussion of what the academic research says, we all could learn how to achieve financial freedom many years sooner than has ever before been possible for average people.

    Lots of blogs help people with spending problems even though the credit-card companies would prefer that we encourage people to overspend to the max. All we really need to do is to take what has worked in the spending area and apply it in the investing area. We should be aiming to help our readers, not to serve as stenographers for The Stock-Selling Industry.

    I certainly wish you the best in any event. Thanks much for stopping by.


  4. Until then valuation informed indexing will probably remain little more than an interesting theory, but not one strong enough to warrant abandoning buy-and-hold.

    There’s lots of evidence supporting what you say, Kevin.

    All I can say in response is that it pains me to see the economic crisis worsen when bringing it to an end would be so easy and so wonderful for every single person alive on Planet Earth today. It could be that we will soon get some big names working on our side and things will change quickly.

    Perhaps not. But I definitely think it is better to be a willful optimist than to become defeatist. So I am going to continue to look on the bright side despite a mountain of evidence showing that we are probably going to need to see things get a lot worse before we will be able to work up the courage needed to turn things around.

    Heaven help us all!


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