How We Ruined Our Economy – And How We Can Rebuild It

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Beyond Buy-and-Hold

By Rob Bennett

Our economy is a mess.

The premise of this new column (you’ll see it in this space each Wednesday morning) is that Buy-and-Hold has failed. Each column entry will examine a different principle of Buy-and-Hold Investing, explain why we now know that things don’t work in the way that the Buy-and-Holders say they do, and describe what those of us who believe in the Valuation-Informed Indexing Model (the alternative to Buy-and-Hold) believe instead.

The focus of this first column entry is — How Buy-and-Hold caused the economic crisis and how switching from Buy-and-Hold to Valuation-Informed Indexing will bring about a recovery.

The development of the Buy-and-Hold Model represented a huge advance in our understanding of how stock investing works. In earlier days, most investing analysis was rooted in subjectivity. One expert said one thing, another said another thing, and there was really no way for non-experts to know what to believe.

The pioneers of the Buy-and-Hold Model changed that by rooting their investing strategies in academic research and in the historical stock-return data. They made investing analysis objective. We all owe them our gratitude for doing so. We are going to be seeing huge economic growth in future years as a result of the courage and intelligence it took for them to take that step.

Unfortunately, the First Draft effort at developing an objective approach to investing contained a few eensy, teensy analytical boo boos. Humans! Whatchagonnado?

Where it all started

The mistake that ruined the pie was the one made by Chicago University Economist Eugene Fama. Fama believed that the market is automatically efficient. That means that investors, acting in their self interest, always set stock prices roughly where they ought to be.

Have you ever wondered why it is that you take price into consideration when buying everything you buy in this Consumer Wonderland of ours except stocks? You can thank (or blame!) Fama for that one.

If Fama were right, it would not be possible for stocks ever to be dramatically overpriced. That’s why you’re often told that there is no need to lower your stock allocation even when valuation levels are insane. Under the Buy-and-Hold Model, insane levels of overvaluation are impossible. So the experts don’t know what to tell you to do when they show up!

It turns out that Fama is wrong. Yale Professor Robert Shiller tested Fama’s hypothesis in 1981 and learned that, no, the market really is not automatically efficient, insane overvaluation really is possible, and investors really do need to be sure to lower their stock allocations when prices go nuts if they want to enjoy any hope of long-term success.

Oops!

For complicated reasons (which we will explore in future columns), The Stock-Selling Industry elected to keep this all hushed up for the past 30 years. The result is that all price discipline was removed from the market. No one thought price mattered much. So no one bothered to tell you that it was imperative that you lower your stock allocation during the years when it was very important both to you personally and to the economy as a whole that you do so.

A market in which no one is paying attention to price is a car without brakes. By 2000, we had overpriced stocks to the tune of $12 trillion.

Overvaluation always goes “poof!” over the course of about 10 years, and, as that amount of spending power left our economy, many businesses have felt the strain and been forced to let millions of workers go. Voila! Economic Crisis Supreme!

We are not doomed

Shiller’s findings are revolutionary. The Shiller model (Valuation-Informed Indexing) shows us how to invest in a way that permits us all to earn far higher returns while taking on far less risk. When we learn what works, we will feel less panicky about our financial futures. The animal spirits that drive the free market economy will be set free again.

The reality is that we may end up someday looking back at this economic crisis as the best thing that ever happened to us. Many of us were not open to hearing the message for as long as Buy-and-Hold had not done too much damage, but now that we appear to be headed into the Second Great Depression, more and more people each day are opening their ears to talk of new investing ideas.

That’s what we need! We need new ideas, better ideas, more enriching ideas, more life-affirming ideas!

I hope to be able to put some forward at this column. I have learned a lot about how stock investing really works over the past eight years because of smart and generous people like you who have taken time out of their days to share their thinking and thereby helped us all to Learn Together. I hope to do more of that here.

I need your help to make it work. Don’t let me down! We have an economy to save!

Rob Bennett is a new staff writer at OutOfYourRut.com and the creator of The Stock-Return Predictor. Rob is also the owner and creator of A Rich Life, a blog that aims to put the “personal” back into “personal finance”. Rob developed the Passion Saving approach to money management as well as the Valuation-Informed Indexing investing strategy, both of which are described on his blog.

( Photo courtesy of Katrina.Tuliao )

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One Response to How We Ruined Our Economy – And How We Can Rebuild It

  1. Fascinating topic. I agree there are valuations on the high or low side that make no sense. A stock, EMC, whose growth in 1999 had decades of doubling every two years. Great history, but it simply couldn’t continue, lest its valuation soon exceed the entire market for all the product sold in its niche (storage for business, think banks, google, streamed video). I’m no genius, so I missed the exact top, but it fell from over $100 to $4 or so. I got back in at $5. Good margins, a still growing demand, no bankruptcy in their future.

    I can do this for a rare handful of stocks over time, but not the market as a whole. I stay indexed for the bulk of out savings, with a mix of some stocks the market seems to have mispriced.

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