Monday, May 3, 2010

Stock Investing: Much of Today's Understanding is Primitive

Originally posted at DBKP: Stock Investing: Much of Today’s Understanding is Primitive

I Know More About Investing Than John Bogle

-- And You Can Too!

It’s not that I’m picking on Vanguard Founder John Bogle. Bogle is a hero of mine. The point that I want to make is that none of the investing experts know as much as they are portrayed to know about stock investing. Today’s understanding of how stock investing works is primitive. This reality gives you an opportunity to shoot ahead of the experts if you are willing to question a few of the most popular beliefs that we have discovered in recent years are built on sand.

It’s not just me who says that our knowledge today is primitive. Rob Arnott is the former editor of the Financial Analysts Journal, the most prestigious journal in the field. He says that today’s conventional investing wisdom is rooted in “myth and urban legend.” Anatole Kaletsky wrote in The Times that the economic theories on which today’s conventional investing wisdom is based are “on the brink of a paradigm shift." We are where astronomy was when Copernicus realized that the earth revolves around the sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.”

So you don’t need to take “experts” like John Bogle too seriously. Bogle is a smart fellow. I have learned many important things from reading his work. But when he says something that does not add up, I remind myself that the conventional investing wisdom that he espouses is rooted in myth and urban legend and I think the issue through for myself until I come to an understanding in which I am able to feel greater confidence.

The thing that I don’t get about Bogle’s advice is why he says that there is no need for investors to lower their stock allocations when stock prices go to insanely dangerous levels. Bogle acknowledges that stock prices always revert to the mean; he calls this an “Iron Law” of stock investing. The market was priced at three times fair value in January 2000. That translates into $12 trillion of overvaluation, $12 trillion of money that investors were thinking could be used to finance their retirements that was fated to go “poof!” sometime over the following 10 or 15 years. Shouldn’t we have all been expecting a stock crash as the Iron Law forced prices back to fair value? It sure seems so to me.

I’ve studied the history of the Buy-and-Hold concept to try to figure out what is going on with the strange advice that we have been hearing from most of the experts for the past 30 years. It turns out that there was a time when the academic research really did support the Buy-and-Hold idea. There was a time when the research seemed to indicate that stocks are always priced properly, that insane levels of overvaluation are an impossibility. If that were so, staying at the same stock allocation at all times really would make sense.

But Yale Professor Robert Shiller (author of Irrational Exuberance) did research in 1981 poking holes in the idea that stocks are always priced right. If Shiller’s findings hold up (and there is now 30 years of follow-up research backing him up), staying at the same stock allocation at all times is a terrible idea. If Shiller is right, Bogle is wrong. If valuations affect long-term returns, the risk of investing in stocks is greater at times of high prices. If Shiller is right, the investor seeking to “Stay the Course” (a favorite Bogle admonition) needs to change his allocation in response to big price swings, not always keep it the same.

Why haven’t the experts been telling us this? Buy-and-Hold became extremely popular during the huge bull market. Advocating Buy-and-Hold made a lot of people millionaires. I have a funny feeling that the primary expertise of many of the “experts” in the The Stock-Selling Industry is in marketing. Buy-and-Hold teaches that we should all always be putting most of our money into stocks. Wouldn’t every industry like to be able to persuade the public that its product is a good deal at any possible price? The Stock-Selling Industry actually got away with this far-fetched (and self-serving!) claim during the Buy-and-Hold Era.

Are you depressed? Please don’t be. What I am saying is encouraging news if you look at it from the right angle.

I am saying that the conventional investing wisdom is dubious stuff. That’s bad. But you know what? There is no law that says that we need to follow the conventional wisdom. What if we stopped?

If the conventional wisdom is as bad as I am arguing it is, there are wonderful opportunities available to all of us to invest far more effectively just by taking a little time to learn what the academic research really does say rather than going by what the expert salesmen say that it says. If valuations affect long-term returns, as the research has been showing for 30 years now, we can all easily obtain far higher returns at far less risk. How? All we need to do is to lower our stock allocations when stocks are priced to provide poor long-term returns and increase our stock allocations when stocks are priced to provide super long-term returns.

If Shiller is right, stock returns are predictable. To the extent that stock returns are predictable, stocks are not risky. You can get the great returns available to those who invest in stocks without having to expose your retirement money to much risk of loss. All you have to do is to be willing to adopt a more skeptical attitude to the claims of John Bogle and the other expert salesmen.

More to come!

by Rob Bennett
* Primitive Thinkers
* Canuck Jihad

Rob Bennett recently posted a Google Knol arguing that “The Bull Market Caused the Economic Crisis.” His bio is here.

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