The Economic Crisis is the Best Thing that Ever Happened to Us
This is a guest post by Rob Bennett. Rob often writes on behavioral finance on the Passion Saving blog. You can learn more about Rob’s background on his bio page.
You get fired.
You’re feeling very, very, very down. And scared about the future.
What do your friends tell you?
They tell you that someday you will look back at the firing as having been a good thing.
It doesn’t seem possible at the time that that could turn out to be true. It’s just nice people saying a nice thing. But you know what? I have heard lots of real-life stories in which it did indeed turn out to be true. I have had this happen in my own life.
People who get fired are usually not dumb people or lazy people or bad people. But there’s usually a reason why they got fired. There was a mismatch between what they were good at and what their employer needed from them. For any of dozens of possible reasons, both the employer and the employee put off dealing with the problem until the effects of the mismatch became so painful that a firing was the only way to force a change.
That’s what is going on with this economic crisis. It is a terribly painful thing for just about all of us. But I believe that there is going to come a day when we are all going to look back at it as the best thing that ever happened to us. I believe that there is today a mismatch between how we think stocks work and how stocks really do work that must be addressed and that the mismatch has been ignored for so long that a point was reached at which an economic crisis was the only way to force a change.
I am the world’s leading critic of Buy-and-Hold Investing. Buy-and-Hold teaches investors that it is okay (or even a good idea!) not to change their stock allocations when stock prices rise to insanely dangerous levels (as they did in the late 1990s). I want to see Buy-and-Hold supplanted by Valuation-Informed Indexing, a strategy that posits that investors must change their stock allocations if they are to have any hope whatsoever of keeping their risk profiles roughly constant.
Bret (the owner of this blog) was kind enough to link to an article of mine not too long ago. Along with his link he quite properly put forward words expressing his skepticism as to whether most investors would be able to follow a strategy in which they must lower their stock allocation when prices are moving quickly up and increase their stock allocation when prices are going quickly down. Bret observed: ”It’s easier to pry a pit bull off your ankle than it is to get someone to sell a stock after it has gone up 80 percent.”
He’s right. Our natural inclination is to buy stocks when prices are going up and to sell stocks when prices are going down. So how do I expect to get this Valuation-Informed Indexing thing off the ground?
Our natural inclination is wrong. It is rooted in emotion, not reason. It’s a mathematical reality that stocks are more risky when prices are high than they are when prices are moderate or low; there has never once been a long-lasting stock crash that started from a time when prices were reasonable and there has never once been a time when prices were at the levels we saw from 1996 through 2008 when prices did not crash hard. So we know intellectually how to avoid most of the risk of stock investing — pay attention to valuations when setting our stock allocation. We just don’t do it. Because our emotions pull us in the other direction.
It is the job of our investing strategies to protect us from self-destructive emotional inclinations. An investing expert that teaches that it is “okay” to stay at the same stock allocation after valuations rise dramatically is to my mind akin to a doctor that tells his patients that it is okay to eat six pieces of chocolate cake each night because he knows that doing that will make him popular. It is sometimes the job of an expert to tell his clients and listeners and readers things they very much do not want to hear but very much need to hear.
It’s never been done that way. I hear that comeback all the time.
My response is to point out that things change. There has never before been millions of middle-class people invested in stocks to finance their retirements. What worked in earlier days does not work in a day in which a stock crash causes millions to become afraid to spend money and thereby craters the entire economy. The stock market and the economy are now connected. We are going to have to start giving better investing advice if we are to realistically expect our economy someday to become a fully functioning one once again.
We can prevent stock crashes. If we impress on investors that stocks offer a poor long-term value proposition when they are overpriced, people will learn to sell at the first sign of significant overvaluation. Which will bring prices down. Which will cure the overvaluation problem. Market prices are self-correcting once investors understand that the first rule of long-term investing is to never, never, never give thought to staying at the same stock allocation at all times,.
We’ve “known” all this for a long time. The academic research showing that valuations affect long-term returns was published in 1981. For 30 years, we have been pretending that we didn’t know what anyone following the literature did know. Because we are humans. Because we let our emotions overrule our intellect. Because we don’t like change.
We all messed up. We have all been fired.
Lucky us! We are through this painful experience now being presented with an opportunity to move on to something a lot better!
Just do an annual or even semi annual rebalancing. This forces you back to your planned asset allocation. You take profits from what has run up (sell high)and you invest in what has lagged (buy low). Its a mechanical system that takes any emotion out of the equation. It works.
Steven:
This is Rob, the fellow who wrote the Guest Blog Entry. Thanks so much for stopping by and sharing your thoughts.
You are right to point out that rebalancing takes you a little bit of a step in the right direction. But it does not come close to doing the job that needs to be done. Here is the URL for The Stock-Return Predictor, a calculator at my web site:
http://www.passionsaving.com/stock-valuation.html
The Predictor runs a regression analysis of the historical stock-return data to identify the most likely annualized 10-year return starting from any of the possible starting-point valuation levels. Plug in a P/E10 value of 8, the P/E10 that applied in 1982, and you will see that the most likely annualized 10-year return for stocks purchased at those price levels is 15 percent real. For stocks purchased at the price level that applied in 2000, the most likely annualized 10-year return is a negative 1 percent real.
There is no one stock allocation that makes sense both when the most likely long-term return is 15 percent real and when it is a negative 1 percent real. Rebalancing only brings you back to the stock allocation you were at before. To keep your risk level constant, you need to adjust your allocation in response to big valuation shifts. You need to go with lower stock allocations when prices are high and higher stock allocations when prices are low.
It might help to take a look at a column that was published in the Wall Street Journal last week:
http://online.wsj.com/article/SB10001424052748703440004575548253340306596.html
The column explains that the idea that long-term market timing doesn’t work is a myth. No one has been able to put forward any logical argument for why long-term timing would not work and the entire historical record shows that in fact it always HAS worked. The claim that investors don’t need to change their stock allocations when prices go to insanely dangerous levels is a marketing gimmick, nothing more and nothing less. The stock investor’s goal should be to keep his risk level roughly constant.
I am no investing expert. There are lots of smart and good people who strongly disagree with me. I am just reporting to you my sincere beliefs re these questions. I know from experience that people sometimes get upset when I say these things. It is not my intent to upset anyone. I believe that these are important questions and that people need to be talking them over and thinking them over. I feel that I do my part by getting them out before people. I of course understand that many do not find merit in them.
Rob
I’ve seen your comments on a few sites now, Rob, and I’ve found them interesting. It’s always good to read something new that challenges your way of thinking. What metrics do you use to measure high and low valuations?
It’s always good to read something new that challenges your way of thinking.
Thanks so much for those kind words, Invest It Wisely.
What metrics do you use to measure high and low valuations?
I use P/E10. That is the current price of the S&P over the average of earnings for the last 10 years. This is the metric used by Yale Economics Professor Robert Shiller (author of “Irrational Exuberance”). Shiller got it from Benjamin Graham, mentor to Warren Buffett. Graham first wrote about P/E10 in the early 1930s, in his classic book “Security Analysis.”
There are other good metrics. Tobin’s Q works well. Andrew Smithers (the author of “Valuing Wall Street”) recommends Tobin’s Q.
I am not a numbers guy. If you are interested in the numbers backing up the Valuation-Informed Indexing strategy, you should check out John Walter Russell’s site, http://www.Early-Retirement-Planning-Insights.com. I met John at a Motley Fool discussion board and John then spent the last eight years of his life doing the research that backs up this approach. John died in October 2009 and the site was transferred to me. But I have made no changes. I just pay the annual fee to keep it going so that those interested can check out all of the wonderful work that John did for us all.
Rob
Hi Rob, I don’t know if this economic crisis will be the best thing for most people. I suspect it won’t.
However, I do agree with your position of holding fewer stocks when they are relatively expensive. I’ve been surprised at how controversial this idea is, but if most people are buying and holding, they are emotionally invested in this strategy. I’m not your average investor anyway, as most of my savings are now in precious metals and commodity stocks. I use a measure of relative price to decide if it’s time to buy more, although I rarely sell nowadays.
I don’t know if this economic crisis will be the best thing for most people. I suspect it won’t.
Thanks for your supportive words, Jennifer.
I don’t at all mean to downplay the human suffering we are seeing all around us. My point is that the potential to make huge strides here is just mind-blowing.
People need to look at the numbers. Stocks were overvalued by $12 trillion in 2000. There’s pretty much a universal consensus that Reversion to the Mean is an “Iron Law” (Bogle’s phrase) of stock investing. So we all “knew” in 2000 that our economy would be experiencing the loss of $12 trillion in spending power over the next 10 years or so. And there are people who express surprise that we are today in the second worst economic crisis in our history?
Now look at that from the other side. What if we let people know the realities? What if investors knew to sell stocks when prices got too high? Prices could never get too high again in that scenario! Which means that we might never see another economic crisis (there have been four economic crises since 1900 and every one of them was preceded by a time when stock prices rose to insanely high levels — there has never been a single time when stock prices rose to insanely high levels and we did not see an economic crisis)!
Look at how much we have lost in this crisis. Millions are unemployed; we are losing that work effort. We are spending trillions in stimulus bills; all of that spending would be unnecessary if we had been able to share with people the realities of stock investing when we first learned about them. Tens of thousands of businesses have failed; think of the years of sweat equity that entrepreneurs lost when the rug was pulled out from under them. People were overspending like crazy during the years when the nominal value of their portfolios was three times the real, lasting value; had people known the true value of their portfolios, they could have managed their money far more effectively. We are looking at waste piled on top of waste piled on top of waste.
The question for 30 years now (it was in 1981 that the research was published showing that valuations affect long-term returns) has been — How are we going to get this information out to people so long as The Stock-Selling Industry spends hundreds of millions promoted Buy-and-Hold? I am seeing signs that the economic crisis is bringing people around. People are becoming worried about their futures and more open to more realistic investing strategies.
Once we make that shift, it’s over. Things will just keep getting better and better and better. Understanding how stock investing works is a big deal. We all have a lot of money tied up in the stock market. Getting this right is going to have a huge multiplier effect. And there was just no way to get it right without first having gone through an economic crisis that helped people start to open their minds a bit to new ideas. I know. I have been trying to spread the word about this stuff for over eight years now.
There’s a reason why it is always darkest before the dawn. Sometimes it takes a scary darkness to prompt people to make the changes needed to bring on a reassuring dawn. That’s my take re all this, in any event. I do not at all mean to make light of people’s pain. My aim is to keep people from falling prey to depression. That helps no one. There is a good side to this that we all will be seeing once we make it to the other side (or at least so I believe!).
Rob
Thanks for your thoughtful reply, Rob. I didn’t realize stocks were overvalued by quite that much, although I never really understood why people were paying so much for companies that never made a profit (like Amazon at the time). I certainly believe in reversion to the mean, and that includes falling below the mean before rebounding.
If you could get people to invest more sensibly, that would definitely keep prices from getting out of hand. However, I wonder if it’s human nature to get “irrationally exuberant” about things. Of course, we can always choose to be the smart one in the crowd.
I agree that there has been a huge amount of malinvestment over the past decade. I appreciate your enthusiasm and desire to help people do it better. The people who profited from stocks in the last 10 years were primarily insiders and those who collected commissions from buying and selling (broker-dealers).
Even more than the stock market, I’m concerned about real estate. So many more people were involved in that, and a similar mania occurred.
Rob,
I have really enjoyed this post and some of your assumptions seem pretty sound to me. I do agree that if investors paid more attention to valuation, we would have fewer boom and bust cycles. Some sharp Value investors, such as Warren Buffet, had the discipline to avoid the high valuations before the tech crash and the subprime crisis.
However, I think the overwhelming majority of retail investors, who are just common folk, don’t have that kind of discipline. They always seem to get sucked into whatever is hot, including stocks, real estate and precious metals. I had lots of conversations telling people real estate was overvalued in 2005 and they all looked at me like had I lost my mind.
Maybe a system, like the valuation-informed index, would help investors avoid this problem. But, I think it’s going to be a tough sell to retail investors. And, the investing institutions are definitely going to avoid it, because it will affect their income.
So, it’s up to a few wise investors to carry that flag.
Thanks for your kind words, Bret.
And thanks for giving your readers a chance to hear about the ideas.
Rob
“There was a mismatch between what they were good at and what their employer needed from them”
Perfect!
Most people are working and do not have time to watch their stocks, second if they did have time they are not condition to research and study asset allocation
Okay Rob,
Your article has intrigued me. My immediate inclination is the same as Bret: cool concept but applying it (getting people to sale stock during periods of overvaluation) seems incredibly difficult. However, you have a compelling point of how if we become more sensitive to what overvaluation really means to our portfolios, perhaps our natural desire to keep overpriced stock would change. I will certainly read the other articles you linked too.
perhaps our natural desire to keep overpriced stock would change.
Thanks for keeping an open mind, Roshawn.
I think what is going on here is that many are noting that valuation-informed strategies have never been the most popular strategies before. That’s right. I do not disagree.
But that could be said of many things. Before we had electricity, we never went to baseball games at night. Before we had vaccinations, lots of kids suffered from whooping cough. Before the Civil War, black people had to endure slavery.
Things change! Sometimes for the better!
Things won’t change for the better unless the humans elect to make it happen. But we are the humans! It’s up to us to do this thing! If we want to make it happen, it will happen!
We just need to spread the word. If we give people the tools to invest in valuation-informed ways, they will do it. I have spoken to thousands of middle-class investors about this and I know from personal experience that there are many people who are very excited about these ideas. They want to be able to talk them over with others. They want to have blogs and discussion boards where they can meet and discuss pros and cons. The internet provides us the technology we need to make it all happen. All that we need to do is to get over this reluctance to try something new and just give it a spin.
There is no downside. If the ideas do not pass muster, people will identify the holes in them and they will be shot down. Which is a good thing. If the ideas are not strong, we don’t want to see them survive. But if they are strong, we DO want to see them survive. What we want to do is to put them to the test. We want to have a debate throughout the Personal FInance Blogosphere for the purpose of airing all sorts of views on how to proceed at this point.
If there are any bloggers reading these words who are open to the idea of running guest post on various aspects of this question, please just contact me and I will send some words your way. If you have a particular question that you would like me to address, just let me know what it is and I will write the words to be responsive to that particular question.
Together, we can change the world in a very, very positive way. It’s all upside and there’s no potential downside. Talking things over is ALWAYS a plus, ALWAYS a learning experience. The internet can be a very powerful communications medium if we put it to work serving positive and constructive and life-affirming purposes.
Rob
Property investing is a numbers game. This is why you need to do some serious computations and analysis before locking a deal.
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