Recent Stock Market History Has Too Much Influence on Our Thinking

Beyond Buy-and-Hold #66

By Rob Bennett

I believe that the case against Buy-and-Hold is rock solid. Common sense tells us that it cannot possibly work. There is now 30 years of academic research confirming what common sense tells us. That research is based on 140 years of historical stock-return data. What more could you ask?

Lots of people are asking for more. Buy-and-Hold remains popular. My articles stating the case against it remain unpopular.

I have exchanged a number of e-mails with a fellow who is a big believer in Buy-and-Hold but also not entirely unsympathetic to my case for Valuation-Informed Indexing in an effort to better understand what is going on in people?s minds. This fellow has looked at the research and acknowledges that is appears generally solid. Still, he is not a convert. Buy-and-Hold seems right to him.

He was fair-minded enough to tell me that, following one of our recent e-mail conversations, he laid in bed for a time asking himself what it would take to persuade him that Buy-and-Hold does not work. That?s the question I most need answered. So I listened carefully to what he told me.

The ?this time it?s different? philosophy

He told me that he does not really trust much of the historical stock-return data used in the research that shows that Buy-and-Hold cannot work. Why? That data is old. In recent decades, Buy-and-Hold has done well. It?s the recent data (from 1980 forward) that has the greatest influence on his thinking. To the extent that the data from 1870 through 1980 tells a different story, he discounts it.

I don?t think it is just this one guy. I think this may be the most important reason why so many people have a hard time understanding how stock investing really works. We are all most heavily influenced by what we see going on around us today and in recent days. Stuff that happened 40 years ago or 80 years ago or 120 years ago is old news. It doesn?t seem relevant to our current-day concerns.

I agree to a point. The economy obviously has an effect on stock market developments. And the economy of 2011 is not the economy of 1870. It makes sense to give developments taking place in recent decades more weight in trying to figure out how to invest for your retirement.

The flaw in that thinking

However, there is also a serious problem with this line of thinking.

Buy-and-Hold is rooted in the idea that it is economic developments that determine short-term stock returns. The economy improves, and stock prices go up. The economy gets worse, and stock prices go down. Since the economy is changing every day, it is possible to test the validity of the premise of the Buy-and-Hold model on a daily basis.

Given that the model is either being confirmed or discredited on a daily basis, one could argue that it is possible to gain a good sense of whether Buy-and-Hold works based on three decades of experience. Since recent data is indeed more relevant than data from long ago, it makes a certain amount of sense to permit recent stock-market history to be your guide in deciding whether to go with a Buy-and-Hold strategy or not.

The trouble is that Valuation-Informed Indexing is rooted in a different premise. Valuation-Informed Indexers believe that it is investor emotions that determine stock prices in the short term. This is why long-term returns can be predicted. Long-term returns are determined by the economic realities. So, all that you need to know to be able to predict returns effectively is how far returns have strayed from what they would be if it were the economic realities that were the dominant influence in the short term. That lets you know in which direction returns are headed and how big the move in that direction is likely to be.

The complete bull/bear cycle

Valuation-Informed Indexing cannot be tested on a daily basis. It cannot be tested on a weekly, monthly or yearly basis either. It takes 10 years for the return predictions that make this strategy work to become statistically significant. It takes 35 years or so for an entire bull/bear cycle to play out.

So there is no way to gain a sense of whether Valuation-Informed Indexing is a good model or not without taking into consideration at least 35 years of data. And it?s hard to have much confidence in conclusions based on viewing of only a single cycle. One cycle could of course be a fluke. I am convinced because the cycle that should always apply if Valuation-Informed Indexing is a valid model has repeated over and over again throughout the entire history of the U.S. market. But even I would like to see more cycles (there are three complete cycles now in the record and a fourth cycle that will be complete after the next stock crash).

From the Buy-and-Hold perspective, there is lots of evidence supporting the belief in the dominant model. Stocks have done well from 1980 forward. They obviously have not done as well from 2000 forward as they did from 1980 through 2000. But the overall record is not a bad one. Buy-and-Holders don?t like what they have seen from 2000 forward but don?t feel that 12 years of bad returns is enough to discredit a model that was supported by 20 years of good returns before the 12-year run of bad returns kicked in.

The deciding years will likely be the next five. If the Valuation-Informed Indexing model is valid, we will be seeing another price drop of about 60 percent from where we stand today. A stock crash of that magnitude would be a fourth confirmation of the Valuation-Informed Indexing model. It?s hard to dismiss a model that has been able to predict stock returns far in advance for 140 years and for four complete bull/bear cycles.

If stocks perform well for the next five years, the shaken confidence of the Buy-and-Holders will be restored and the Valuation-Informed Indexers may need to go back to the drawing board.

We?ll see what happens. You know what I am expecting to see. But the full truth is of course that none of us knows for sure.

Rob Bennett has written about what he likes and doesn?t like about Robert Kiyosaki. His bio is here.

 

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Nine Reasons Why Stock Valuations Make a BIG Difference in the Long Run
Risk-Free Stock Investing?

( Photo from Flickr by Helico )

3 Responses to Recent Stock Market History Has Too Much Influence on Our Thinking

  1. Rob – I think your title also applies to bonds. Financial planners and investors look at the benefits bonds have provided portfolios from 1980 – today and believe they should have XX% in bonds. They are not looking at valuation. Treasury Bond yields (reward) have fallen from 14%in 1980 to 3% today. Bond prices (risk) are the highest in a generation. Valuation matters!

  2. Hi Ken–You’re raising an outstanding point that few address anywhere. Bonds have gone straight up for three decades, and with interest rates as low as they are we have to be at the price peak. It’s hard to imagine a scenario in which bonds would be a winning investment right now. The only possibility I see is a deflationary depression where short term rates go to zero, and investors pour into bonds paying 1-2%. If that’s the case then bonds are really a play on dissaster at this point. But then you’d have to worry about safety of principal as debtors ability to repay would be in serious doubt in that economy.

    If I’m right about this then bonds are even more speculative than stocks and best occupying no more than a small percentage of a portfolio. But then I’m a cash guy right now.

  3. I agree, Ken. People certainly need to look at prices when buying bonds too.

    Personally, I don’t think middle-class people need to invest in bonds. I invest in stocks for growth and in IBonds or TIPS as a holding place when stocks are insanely overpriced. The academic research shows that that combination is all you need to obtain perfectly good returns at greatly diminished risk from what 90 percent of investors experience today.

    There’s nothing wrong with bonds. People who want to invest in them should do so. But my view is that you should only invest in what you know well and many people don’t want to take time to understand more than one asset class well. If you are only going to take time to understand one asset class well, make it stocks and just go with some cash-like asset class when stocks are not appropriate.

    Rob

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