The Efficient Market Hypothesis is Flawed

Are you an active or a passive investor?  As with all things in finance (such as the type of investor you are), there are shades of gray, but you can basically break down investing strategies into one of those two categories.

On the one hand, you have the passive investors, the buy and hold guys (and gals).  Usually this crew has a portfolio strategy, like a 60%/40% stock/bond mix, a “Coffeehouse” portfolio, or some other sort of indexing scheme.  Expect it to be well thought out, back-tested, and generally a decent fit for you low information investors I discussed in my last post.

On the other hand?  ‘Frequent’ traders, who are traders of individual stocks and people who are using instruments more complex or volatile than ETFs and Mutual Funds.

Information Warfare

Buy and hold has a huge following – and the truth is, it should.  As my co-writer Cameron recently noted, over the last 10 years the S&P 500 returned 8.4% while the average investor saw 1.9% returns. The vast majority of investors shouldn’t bother with anything more than a passive portfolio – “set it and forget it” is an awesome strategy that won’t keep you awake at night worrying too much about recent volatility.  Although the massive diversification of most buy and hold schemes means that while you capture large swings in the market, you won’t capture the outsized returns which are possible with individual stocks.  Balance that against the greater risk of outsized drops and you recognize the power of passivity.  If you read the previous article I wrote on investor psychology, anyone in the low information category should seriously consider this style.

Even though buy and hold likely commands the most followers, there are tons of passionate investors of an active persuasion.    The tools of the trade in active investing include technical analysis, valuation, momentum trading and all sorts of sub discipline which inform the purchases and sales of individual securities (and sometimes other asset classes like ETFs).  Active traders move in and out of the market more often than passive investors, and even though they are a minority of investors, they capture a majority of press.  It makes sense though – that minority makes the majority of trades – they move the market on a day to day basis, even if their passive friends set the foundation.

The Efficient Market Hypothesis

In the passive corner, the strongest evidence there is that what they are doing is optimal is the theory known as the Efficient Market Hypothesis (and its various offshoots, such as CAPM).  Basically,the Efficient Market Hypothesis says that there can be no edge in the market, that investors are all perfectly rational, and all investors working off public information can’t profit except from inside information (and even then, maybe not), and that all stocks are equally well priced.  There are various degrees of strictness of the theory, but the main point is that the market works like a  Random Walk Down Wall Street.

Passive investing’s spokesmen will point to sheer randomness and luck whenever they are presented with evidence of someone beating the market over a long period of time.  Consider the following… assume you have a 1 in 2 chance of beating the market in any given year.  If that is true, you can see that the odds of you beating the market quickly reduce over a period of years.  However, in a universe where there are 150,000,000 investors investing randomly, getting the ‘coinflips’ right 25 times in a row still leaves 4-5 ‘investors’ who we will now treat as gurus based on sheer luck.  Therefore, we should discount anyone who seems to be lucky, not skilled, over a long period of time.

At this point, a note: In my last article, I gave you a list of people who actually did beat the S&P 500 over a long period of time.  Let me repeat some of them here: Benjamin Graham, David Dodd, Warren Buffett, Irving Kahn, and Walter Schloss.

Why did I pick those specific investors?  Some of you already might recognize that they were either teachers or students of Ben Graham and David Dodd’s value methods, authors of the famous book Security Analysis (and its companion The Intelligent Investor).  Keep that in mind for the next section.

Three Strikes Against the EMH

I don’t consider myself an active investor.  Whenever I buy a stock I try to figure out valuation (what it ‘should‘ be priced) to calculate a potential upside.  When a stock is close to fairly valued?  That’s when I sell.  This process of buy and hold isn’t quite the same as passive portfolios as it requires I keep an eye on a number of metrics, but since my holding periods are generally measured in years I don’t exactly consider myself an active investor.  I don’t belong in either camp.

That said, I can’t accept all of the things stated by the EMH.  Assuming rationality is a wonderful way to come up with a framework for how the markets work and to approximate the movements of the market, but extrapolating one rational being’s decision making to an entire market (where it’s possible that the most active investors are the least rational) is too much to swallow.  Let’s talk about three reasons the EMH falls short:

  1. The Efficient Market Hypothesis assumes that all markets reflect the fair value of all stocks quoted, discounting all publicly available information.  Since at one point before the currently quoted price there was a different price, in order for the current price to be accurate some trader had to have captured the difference in prices in order for the current price quote to be accurate.  He or she may have bought or sold stock to increase/lower the price, but since the price moved, someone must have profited off of it.  Simply, a market participant forced the move to the current price, so someone captured the difference from fair value.
  2. The EMH’s ‘weak’ formulation allows for the occasional flash crash like 1987’s black Monday, but no great answer has emerged as to how, in a rational market, bubbles form and pop.  In what efficient market could an asset have wild swings in price from day to day in the virtual absence of news?  On a smaller scale, why do markets tend to overshoot on surprise bad or good news, only to rebound in the opposite direction?  Examples abound in the latter category – BP during the recent oil spill, Alcoa during the tobacco lawsuits, even banks during the recent recession (although some of that bank mojo, but not all, is government intervention).
  3. Just above I laid out the odds of investors beating the market over long periods of time.  How have 5 value oriented investors – when we said 5 completely random investors would be expected, perhaps, from odds alone – beat the market over such a long period of time?  Note that Graham started teaching value investing in 1928 – so you’re talking about his methods prevailing over an absurd period of 84 years at this point (a far cry more than 25 years).  Having proponents of the same theory all outperforming the market is the third strike for the EMH.

What Could Beat the Random Walk Style of Investing?

If you agree that the EMH is flawed, you’re probably wondering ‘what can possibly beat random walk investing’?  That’s simple, it can be one of three things:

  1. A leading indicator of future performance which hasn’t yet been recognized.  The ultimate example is the price/sales ratio, first popularized by Ken Fisher of Fisher Investments fame.
  2. An asset class which is more likely to be overlooked, misunderstood or ignored by the market.  The ultimate example of this would be small capitalization stocks.  The definition varies, but generally large funds will avoid buying stakes in smaller stocks (they don’t want to ‘accidentally’ buy voting control, or they have institutional controls preventing it).  Another recent example would be mortgage backed securities – where a number of investors found a way to make a killing while the market tanked.
  3. A methodology which requires work or a personality trait which isn’t present in other investors.  This is where value investing falls into the mix – since fund returns are measured on a quarterly and yearly basis, an individual investor can out-wait a large fund, which has to impress investors quarter after quarter.  Value investors might under-perform for years only to gain many years worth of returns in a few months – any funds attempting that sort of strategy would be closed well beforehand.  Another example is activist investing and private equity, where extreme amounts of work can lean down a company and cause it to reevaluate things, improving outlook at a firm.

Do You Have Any Specific Evidence to Support This?

The most famous example is probably Robert Schiller’s, when he graphed the P/E10 (the average price to earnings of the S&P 500 over the rolling ten year period) versus earnings.  That graph clearly shows a negative correlation with high valuations and returns… in essence, valuation works on the market as a whole to inform decisions on how and when to invest.

I mentioned Private Equity.  Is there any evidence activist investing and private equity beats the market?  Well, yes, again there is plenty of evidence.  (As a side note, I don’t know why Mr. Arends is so angry about this study – the PE firms are putting up their capital and doing lots of work restructuring these firms, so you’d hope they can capture some excess returns).

How about small caps beating the market?  Here’s what I’ve got.  I could dig around for other asset classes too, but you can use Google just as easily as I can.  As for people making money on misunderstood asset classes, like say, by shorting mortgage backed securities?  I’d go with Michael Lewis’s The Big Short.

And valuation methods which aren’t yet widely known in the larger market?  Do a bit of reading on Ken Fisher and you’ll see that as his PSR became well known its predictive value started to fall – an important point for anything that can fall into category 1 above.

All of that points to one conclusion: there is a way to beat the market.  It may be temporary, it may be difficult, and it may take patience – but there has to be a way.

Do you consider yourself an active or a passive investor?  What do you think of the Efficient Market Hypothesis?  Can market be ‘beat’?  What’s your strategy for investing?

Comments

  1. says

    Actively passive investor here. As I am in the accumulation phase of my long-term plans, and will be for some time, I add to my portfolio regularly, to add to securities that I already own. Actively buying…passively seeking new investments.

    I find 5-10 securities and run with them. No indexes. I replace a stock when it approaches fair value, or (ideally) when it is bought out by another company.

    My strategy is to build in a huge margin of safety to find companies selling for a big discount to what I perceive to be their fair value. In particular, I like net-nets where companies have almost as much net assets as the company is worth. I compare it to buying a rental home for sale for $100k renting for $2k per month with $80k in cash in the basement. I’d buy that any day of the week – as would most people, I imagine.

    Failing that I can’t find a good net-net (haven’t in awhile – WTT and ADGF were the last ones) I like cyclical stocks that are weak for some stupid reason like investor fears. ACAS is a great example – it has a ton of assets in excess of the stock price, but fears about Europe keep it undervalued. Ford may be a better example of a cyclical stock I also have exposure to. Also, I like companies that push out key owners like RIG, which pushed dividend investors out as it warned it would stop paying a dividend temporarily.

    95% of the time I buy only small cap or micro cap stocks. It’s not that I particularly like the idea of small firms; they’re just more likely to fit my numbers. There’s too much smart money in the $10B+ companies, and not enough in the companies worth less than that. And there’s zero smart money in companies with <$500 million market caps.

    Disclosure: I own ACAS, F, RIG.

    • says

      Sounds like my strategy – my wife and I own 7 individual stocks (and to you buy and hold types, a bunch of funds in other accounts). On that note, I think you’ll particularly like article three in this, ahem, “series” (it’s too loose for that, but they do go together).

      Really, I’m using these articles to anger Cameron, and goad him into defending the EMH. I think he’s gearing up for a post next week, haha.

    • says

      I hope you’re ready for part 3, when I hocus all over this blog (that’s what to call it, right?).

      If you saw in JT’s answer, I do hedge my bets to some degree. Some of my accounts are full of mutual funds, for things I don’t particularly care to research myself – foreign stocks and REITs and the like. And yes, I do have a broad stock market fund in my 401(k). Bummer. Reputation ruined?

      “Help me get off this fence!” -PK

  2. Paul @ Thefrugaltoad says

    One big hole in EMH is for markets to operate efficiently there needs to be transparency.  The recent financial meltdown revealed how a lack of transparency in derivative type investments nearly destroyed our economy.  

    • says

      I think Cameron is going to come defend EMH at some point, and he pointed out to me offline that I am wildly misinformed about the term ‘information’ and what it means in this context, haha.

      Of course, I agree with you, an dI pointed out that people made loads of money on the way down – by using publicly available disclosures and ‘information’ to predict a crash.

  3. says

    over the last 10 years the S&P 500 returned 8.4% while the average investor saw 1.9% returns. 
    But I went to zero stocks in 1996 and I am today ahead of the Buy-and-Holders. CDs and TIPS and IBonds were paying 4 percent real in the days when stocks were paying a likely long-term return of a negative 1 percent real. That gave me a 5 percent real differential for 10 years running! Add in compounding on that differential for 30 years (I am 55 today) and you are talking about an edge over the Buy-and-Holders in the hundreds of thousands of dollars.

    And it’s not just me. Wade Pfau compared Buy-and-Hold to Valuation-Informed Indexing over the entire historical record and found that VII beat BH in 102 of the 110 rolling 30–year time-periods. Buy-and-Hold has never worked.

    It’s not hard to understand why. There’s only one difference between VII and BH. Valuation-Informed Indexers take price into consideration when making purchase decisions. Is there anyone who would try to argue that it’s a good idea to ignore price when buying cars? Why should anyone believe that this could be a good idea when buying stocks? 

    I believe that the primary “appeal” of Buy-and-Hold is to the people who make a living selling us stocks. The Car Selling Industry would love it if they could make a marketing pitch that cars are always worth buying regardless of price and lots of us fell for it. They can’t get away with it because we are too smart. But The Stock-Selling Industry brings out all these mumbo jumbo marketing slogans and we fall into awe of the “experts.” I don’t see any “there” there. I say it’s all a marketing gimmick. Price always must matter and there is now 140 years of historical data showing that price always does matter.

    Rob

    • says

      I don’t think you’re being fair with this comparison.  You are obviously very meticulous with your investing – my concern isn’t that your strategy isn’t viable, it’s that it may be hard for other investors to implement.  It’s a weird comparison but consider birth control – we have two numbers which denote how successful birth control is: first, ‘perfect use failure rate’.  Someone might say ‘If you use this method perfectly you only have a .1% chance of a pregnancy a year’.  There is also a second number – ‘typical use failure rate’.  I’m afraid you’re comparing the perfect use (or at least a very good use) of your strategy which you implemented, and are comparing it to average investors who are (you guessed it) typical users.

      Not knowing what date you moved to cash is a problem, but even with price return only you’re talking 5.15% annualized.  Return with dividend reinvestment (again, assuming ‘perfect use’) you’re talking something higher – but forgive me for not doing that math right now.  Did you beat 5.15% annualized from 1996 until Friday?

      The question I’m posing is, basically, most people have an emotional investment in the stock market – will this theoretical investor do better under a certain method?  Why?  If we assume they have issues with buy and hold, wouldn’t they also have issues with valuation?

  4. says

    [i]“set it and forget it” is an awesome strategy that won’t keep you awake at night worrying too much about recent volatility.[/i]
    The historical data does not support this assertion, PK.

    There have been four times in U.S. history when the P/E10 level rose to the “insanely dangerous” level (25). In each of the first three cases we saw a wipeout of the accumulated wealth of a lifetime for all Buy-and-Holders AND an economic crisis for the society that tolerated widespread promotion of this “strategy.”

    I think people say this sort of thing because they don’t adjust for valuations before looking at where the Buy-and-Holders stand today. We always see a drop to a P/E10 of 7 or 8 in the wake of out-of-control bull markets (there is not yet one exception in the record). If we see that again this time, we will be seeing another price crash of 65 percent sometime over the next few years.

    Is there anyone who seriously thinks that our economy will be able to take that hit without us going into the Second Great Depression?

    People need to understand that, when stocks are overvalued, the number on their portfolio statement does not indicate the true amount of wealth held in that portfolio. Stocks were priced at three times fair value in 2000. That means that someone with a portfolio nominally priced at $900,000 possessed a portfolio with a real and lasting value of $300,000. That’s what the word “overvalued” means — it means the nominal price is wrong.

    The total amount of overvaluation in 2000 was $12 trillion. Stock prices always return to fair-value levels after the passage of about 10 years of time (even John Bogle acknowledges this much). Is there anyone who seriously believes that the loss of $12 trillion worth of buying power from our economy was not going to cause an economic crisis? 

    Buy-and-Hold caused the economic crisis. It’s not worth it. We should buy stocks the way we buy everything else — with price considerations always in mind.

    Rob

    • says

       Rob, I know the historical data says (because my cowriter linked it) that the average investor returned 1.9% annualized or so over the last 10 years.  That’s pretty rough.  But in that same article, we found out that perfect buy and hold of the S&P 500 would have returned a whopping 8.4%.  Here’s my conundrum – perhaps with valuation you returned 8.5% annually, and that’s great (for example).  However, isn’t the low hanging fruit these active investors who should be passive?  Going from 1.9 to 8.4 (a year!) is a much bigger deal than the additional .1 percentage point of alpha you’d get using valuation.

      What I’m saying is, for most people, B&H is better than the alternative – super emotional buy sells which led to an almost 6% annualized under-performance over the last 10 years.

      If the average investor is buying highs and selling lows due to their emotions, it doesn’t make a single difference if they are using value.  In fact, buy and hold might be superior because they check the market less – they don’t see the S&P 500’s volatility like they would if they were monitoring PE10, so they just ‘leave it’ and don’t sell the bottom of the market.

      And I don’t dispute perfect tracking of PE10 had some out-performance.  What I’m saying is before more people optimize the type of super car they drive, they need to learn how to drive their beater.

      • says

        What I’m saying is, for most people, B&H is better than the alternative – super emotional buy sells 
        There’s one sense in which I strongly agree and there’s one sense in which I strongly disagree, PK.

        My view is that the finding of the Buy-and-Holders that short-term timing doesn’t work is the second most important finding in the history of investing analysis. You are comparing Buy-and-Holders to those who engage in short-term timing. I strongly agree that investors should disdain short-term timing. So I am with you to that extent.

        The trouble is that, if you tell investors to disdain all forms of timing, you give up the benefits of the most important finding in the history of investing analysis, Shiller’s finding that long-term timing always works. If it were just that that finding yields some extra returns to those who are aware of it, it would indeed be right to say that Buy-and-Hold represents an advance over what came before (short-term timing), just not the biggest advance possible.

        The full reality here is that the phrase “long-term timing” signifies the same thing as the phrase “paying attention to price.” Investors who fail to engage in long-term timing are ignoring price when making investing decisions.

        When large numbers of investors come to believe that it is okay to ignore price, we are all headed for disaster. Once investors start ignoring price, the market becomes dysfunctional. Once investors start ignoring price, prices shoot up so high that we experience a price crash and the economic crisis that inevitably follows.

        I certainly agree that the Buy-and-Holders achieved a major advance with their insight that short-term timing doesn’t work. But I say that we MUST distinguish short-term timing from long-term timing if that insight if to bear good fruit in the real world. We don’t want to go back to where we were before Buy-and-Hold, when investors were trying to guess which way prices were headed in the short term. But we don’t want this economic crisis to take us into the Second Great Depression either.

        BOTH insights are of huge value. We should just tell investors the truth. Short-term timing really is a disaster, the Buy-and-Holders are right about that one. And long-term timing is absolutely required and should be encouraged in every possible way. We need to DISTINGUISH the form of timing that never works from the form of timing that always works and make the necessary changes in our model for understanding how stock investing works to bring the model into line with what the academic research of the past 30 years shows to be the reality.

        Rob

  5. says

    Active traders move in and out of the market more often than passive investors
    This is not necessarily so (if you are classifying Valuation-Informed Indexers as “active” and Buy-and-Holders as passive, as I believe you are).

    Stocks were selling at good prices from 1975 through 1995. There was no need for Valuation-Informed Indexers to change their allocations for those 20 years. Stocks have now been selling at poor prices since 1996. There has been no need for Valuation-Informed Indexers to change their allocations for those 16 years. As a general rule, Valuation-Informed Indexers make about one allocation change every 10 years or so.

    Many (most?) Buy-and-Holders have changed their stock allocations since the 2008 crash. Those who have not yet made changes will almost certainly be making changes after the next crash. Buy-and-Holders say that they never will change their allocations. But is there any evidence that there has ever been a Buy-and-Holder who stuck by this vow through an entire secular bull/secular bear cycle? I have never heard a single name put forward.

    I would expect that in the long term Valuation-Informed Indexers would make fewer allocation changes than Buy-and-Holders. The magic of VII is that the investor is keeping his risk profile constant (stocks are obviously more risky at times of high prices, so one must be willing to change his allocation if one hopes to keep his risk profile roughly constant). Investors who keep their risk profiles constant are far less likely to make intensely emotional decisions. 

    Buy-and-Holders talk the long-term investing talk. But they don’t walk the long-term investing walk. If Buy-and-Holders never sold, prices would never drop to the low valuation levels we always see in the wake of out-of-control bulls. Too many analysts accept the vows of the Buy-and-Holders without checking the historical record to see what sort of real-world results those taking these vows saw in the long term.

    Rob

    • says

       Again, I think you’re being unfair here.  You’re assuming ‘perfect usage’ of VII and ‘typical usage’ of Buy and Hold.  I’m sure there are some people using a 60/40 or a Coffeehouse Portfolio who did hold on during the downturn.

      I’m also sure that there are some people who watch index values who panicked and bought on the way up (it’s tough to hold onto fixed income for 10+ years), only to sell again in the downturn.

      For both methods, unless you can keep your emotions in check, you will do something that you “aren’t supposed to”.  That’s inevitable.

      The other reason you don’t hear about the B&H crew?  They’re more anonymous – if it’s so easy to be ‘average’ why would the press hype them up?  It’s the bias of the unseen – but I’m sure there is some B&H person out there who did hold on through the downturn.

      • says

        I’m sure there is some B&H person out there who did hold on through the downturn.
        There are some Buy-and-Holders who have panicked. But there are certainly many who have not. My guess is that the majority have so far stayed pretty much true to Buy-and-Hold.

        But we are only about halfway through this downturn.

        In the crash that followed the three earlier runaway bulls, we ended up at a P/E10 value of 7 or 8, half of fair-value. That’s a 65 percent price drop from where we are today. How many Buy-and-Holders do you think will hold through that, coming on top of what we have already experienced? My guess is that the number is a number closely approximating zero.

        In the wake of each of the three earlier runaway bulls, stocks performed poorly for 20 years. Think what that does to the economy! People use these calculators assuming annual growth in their money of 6 percent real and then they go 20 years with zero growth or perhaps even negative growth. How much do you think those people feel comfortable spending on houses and cars and vacations for many years to come?

        Bull markets are like credit-card spending on a massive scale. All we are doing is pumping up portfolio statements by borrowing trillions of dollars from future investors, just as those with credit cards buy things they cannot really afford by taking on debt. There’s nothing wrong with our economy today except for the unfortunate reality that we have a $12 trillion debt to pay off that we incurred during the wonderful bull of the late 1990s.

        It was Buy-and-Hold that caused that bull market. If we had told investors they were delaying their retirements for years by failing to lower their stock allocations, millions of people would have sold stocks and thereby killed that bull.

        I learned the power of saving in 1990s. It was because of what I learned on the saving side that I became suspicious when I heard Buy-and-Holders tell me that stocks are the one thing I can buy where it makes zero difference what the price is. That sounded like a marketing pitch to me. So I checked the research. And, indeed, I found that there is 30 years of research showing that price matters as much when buying stocks as it does when buying anything else.

        I can not tell my readers to avoid credit-card debt on Monday, Wednesday and Friday and then tell them to follow Buy-and-Hold investing strategies on Tuesday, Thursday and Saturday. If I believe that prices matter and that paying attention to prices can enhance your enjoyment of life, I need to be consistent with that message and employ it not only in the saving realm but in the investing realm as well.

        Most people spend more money on stocks in the course of a lifetime than they do on anything else they buy. To ignore price in this one area can undo all the good you do paying attention to price on your purchases of everything you buy other than stocks.

        Rob

  6. says

    A leading indicator of future performance which hasn’t yet been recognized.
    It doesn’t have to be something which hasn’t yet been recognized. It just has to be something that has not yet been widely accepted.

    P/E10 is not new. Benjamin Graham put the concept forward in the 1930s. Shiller has been writing about it and researching it for decades. 

    But most of today’s investors don’t look at P/E10 (the price-tag of stocks) when setting their stock allocations. For those investors, P/E10 might as well not exist. No tool can help investors who willfully refuse to make use of it.

    The implicit thought in the words quoted above is that investors are rational and will take advantage of any tools with a proven track record. Says who? If investors were rational, we wouldn’t need P/E10! Overvaluation is irrational. P/E10 would serve no purpose if investors were capable of investing rationally without it.

    Is smoking rational?

    Is overeating rational?

    Is excessive gambling rational?

    Given how humans behave in every other life endeavor, how did this idea ever catch on that the humans will magically become 100 percent rational when it comes time to make investing decisions? I am aware of zero support in the academic research for this core belief of the Buy-and-Holders.

    Rob

    • says

      You’re right – my point wasn’t broad enough.  It could be something which already exists and hasn’t yet been appreciated.  In fact, it’s because of our biases that people who subscribe to Behavioral Finance (in fact, I’m surprised you don’t cite the BF guys more in these comments) think that it’s possible there is a persistent bias against value stocks.

      Applying value to an index is completely consistent with that research.  It’s also completely ignored by many Economists, even though a few Nobels have been handed out!

      • says

        I’m surprised you don’t cite the BF guys more in these comments
        It certainly would be fair to say that I am in the Behavioral Finance school.

        My one beef with others in this school is that they do not devote enough attention to giving practical investing advice. I rate Shiller’s Irrational Exuerbance. as the best book ever published on stock investing. But you can read the entire 300 pages and not come across one paragraph that tells you what to do with your retirement money!

        And there are no web sites that do this today. This is incredible! Shiller’s book received great reviews and was a bestseller. But there is not one web site that I have been able to find that tells people how they should invest differently because they were persuaded by the contents of that book.

        I’ve adopted that as my niche. I start with a belief that the Behavioral Finance people are right. I don’t usually argue that point because others who have come before me have done a perfectly good job of it. Instead, I take it to the next step. I ask: “If the Behavioral Finance people are right, how should people invest?”

        If the Behavioral Finance people are wrong, everything I say is wrong. A belief that the Behavioral Finance people are right is the foundation of every calculator I have developed and of every RobCast I have recorded and of every article I have written. 

        It surprises me and stuns me and amazes me that no one else has jumped into this niche. I believe that, if the perception grows that Buy-and-Hold has failed, this will become the hottest niche in the world. And it’s a money niche! In ordinary circumstances I wouldn’t want to encourage competition but the reality is that I would be better off if I had some competitors. The biggest reason why some people don’t buy what I am saying is that no one else is saying it!

        Rob

    • says

      You could help us all out by encouraging debate on this topic, Bichon.

      I wish you would.

      If you ever would like space at my blog to make the case for Buy-and-Hold, please consider yourself warmly invited to make us of it.

      We’re all in this together. We all want the same things. We all are seeking to become better investors. 

      I wish you the best in all your future life endeavors, in any event.

      Rob

      • says

        Tres Sympathique M. Bennett.  Mais, I will have to kindly decline.  I don’t need that headache.  I get enough just lurking over at the Retire Early home page from time to time.  I appreciate the well wishes and hope the same for you, especially on the sale of your home.  Good luck! and good “debating.”   

  7. says

    All of that points to one conclusion: there is a way to beat the market.  It may be temporary, it may be difficult, and it may take patience 
    Or it might be permanent, easy and not require anything more than a little bit of common sense (the idea that the price you pay for something affects the value proposition you obtain from it is common sense).

    Why assume that there is something difficult about beating the market? I have never seen even a sliver of evidence that this is so. As I mentioned in a comment on the first article in this three-part series, Wade Pfau’s research shows that those willing to take price into consideration have been easily beating the market for 140 years now.

    Buy-and-Holders say that there is no such thing as a free lunch. But why? It seems to me that all human advances are a free lunch for those of us who take advantage of them. Someone invented the car and now I get the free lunch of being able to get from Place A to Place B with a lot more convenience than was available to people in the days when horses were used for transportation. Someone invented the internet and now I get the free lunch of being able to do research without having to walk to the library. Free lunches are all over the place!

    There was once a time when it was hard to beat the market. In the days before indexing, those seeking to beat the market had to research stocks, like Buffett does. But how much work is it to invest in an index fund and to consider the price you are paying for it when setting your allocation? Nothing could be easier!

    That’s a free lunch. Indexing takes 80 percent of the risk out of stock investing. Those buying individual stocks incur risk because they might pick the wrong ones. But this cannot happen to indexers. Indexing eliminate risk — So long as you don’t ignore prices. Ignore prices and you add a new form of risk back in. But there is no law that says that indexers have to follow Buy-and-Hold strategies.

    Why not combine what Buffett does (limit his investing to sound long-term value propositions) with what Bogle does (invest in indexes)? This is the best of all worlds. With this approach (Valuation-Informed Indexing), you do away with 80 percent of the risk of stock investing (by buying an index rather than individual stocks) while not suffering the huge losses that have always been experienced sooner or later by those who buy stocks without taking into consideration whether they are obtaining a strong long-term value proposition or not.

    My view is that Buffett and Bogle go together like chocolate and peanut butter!

    Rob

    • says

      You have to be careful here – remember that if everyone subscribed to this method it would become the average and your free lunch would be rudely snatched away.  In no way do I think it’s a magic bullet – if everyone was concerned with PE10 then PE10 would be discounted by the market.  Like I said, if people start to use something (like, say, Price to Sales), it’s the death bell for that method… at least for generating alpha.

      If everyone sells when PE10 hits 16.4 and everyone buys when it drops below it?  Well guess what – PE10 stayed pegged at 16.4.  No one beats the market!

  8. says

    most people have an emotional investment in the stock market – will this theoretical investor do better under a certain method?  Why?
    Valuation-Informed Indexing takes the emotion and risk out of stock investing. That’s the wonder of it.

    VII is emotionally balanced investing. Say that you hear on the news that the Dow shot up 300 points today. The Buy-and-Holder experiences an emotional thrill, right? The Valuation-Informed Indexer does not. A price gain is a matter of indifference to a Valuation-Informed Indexer. It means that his portfolio is given a higher value. But it also means that his future returns are reduced. The one effect cancels out the other. Price gains are a neutral development for Valuation-Informed Indexers.

    It’s the same with price drops. Buy-and-Holders get panicky when prices crash. Valuation-Informed Indexers do not. A price drop means that his portfolio is given a lower value. But it also means that his future returns are increased. The one effect cancels out the other, just as is the case with price gains.

    The thing that makes investors emotional (and stocks risky) is price changes. But price changes are meaningless noise to Valuation-Informed Indexers. The reason why Buy-and-Holders focus so much on price changes is that under their model price changes are said to be caused by economic and political developments, things of real-world significance. Under the VII model, price changes are said to be caused by investor emotion. They have no significance. We ignore them.

    What matters to the Valuation-Informed Indexer is whether he purchases stocks when they offer a strong long-term value proposition or not. If he does, he is set and he doesn’t need to worry about investing anymore. There’s nothing for him to get emotional about.

    Buy-and-Holders put money on the table without knowing what their long-term return is going to be. Naturally, they are always on the look-out for signs as to what it is going to be. So they get caught up in all the silliness being reported on in the media. The more nonsense they hear, the more they get caught up in the emotion. And, the more they get caught up in the emotion, the more risky stock investing is for them.

    There is no law of the universe that says that stock investing must be risky. It had to be risky before we had index funds and before we had Shiller’s research. But now that we have both of those things, stock investing is risky only for those who elect to make it risky by following Buy-and-Hold strategies.

    Rob

    • says

      Unless you have a VII hedge fund with a long lockup period (or perhaps trading windows so people can get at their money?) I can’t buy that.  Most people will react to market movements – up and down – in the opposite way of what is best for them.  I can’t accept that a  theoretical VII investor doesn’t care when his portfolio is up – I care, and I’m pretty emotionless when it comes to investing.

      Market goes up?  Buy, quickly!  Don’t get left out!
      Market goes down? Woe is me! Sell, sell, sell!

      And there is a law which says stock investing is risky.  Bankruptcy law, specifically.  It says that in the event of company liquidation, stock investors are in the back of the line when it comes to payback.  By that fact alone, which denotes higher risk, stocks should outpace bond gains.

      • says

        Most people will react to market movements – up and down – in the opposite way of what is best for them.
        It certainly has always been that way. This is why many people have a hard time accepting what I am saying. I am saying that we are about to see a “Revolution” (the word used in the subtitle of Shiller’s book) in our understanding of how stock investing works. People don’t like change. People don’t want to go there.

        I believe that it is possible for humans to learn new things and to profit from the learning experience. That’s really all I can say here. I acknowledge that it has always been as you describe. I say that we can use research to teach people about a new and better way. And that, from that point forward, investors will no longer be emotional and stocks will no longer be a risky asset class. 

        We now have in place everything we need to make this dream a reality. We have 30 years of research. We have hundreds of articles. We have hundreds of podcasts. We have five unique calculators. We have a Personal Finance Blogosphere that permits us to communicate these ideas to our fellow investors even if The Stock-Selling Industry is less than excited about the idea.

        We lack one thing today. We lack the will. I believe that that is going to change after the next crash. Then we’re off to the races! I believe that we will soon be entering the greatest period of economic growth ever seen in our history. We just have to work up the courage to accept this great blessing into our lives. 

        Rob

        • says

          I don’t know if it’s will – I think it’s bias towards the short term, often going against what’s for our long term benefit.

          I know you would agree that “even” the buy and hold investors would have been better off if they hadn’t been selling at the bottom, and instead buying more. The only way you’d be able to change psychology is to make a fund with a lockup period/withdrawal restrictions.

          A PE10 fund? That might work. I just can’t see the average investor implementing it in an easy way – the average investor is too quick to sell or buy depending on sentiment. You could short circuit that with a fund, sort of how I suggested stop losses for high emotion investors in the higher article (which I think is a great strategy).

  9. says

    You have to be careful here – remember that if everyone subscribed to this method it would become the average and your free lunch would be rudely snatched away.  
    I don’t think that’s entirely so, PK.

    It is certainly true that, if all became Valuation-Informed Indexers, the outsized gains we have seen for Valuation-Informed Indexing for the past 140 years would disappear. We agree that far.

    But look at what else happens! It’s something very exciting!

    If all become Valuation-Informed Indexers, the market stabilizes. In a  world in which all investors are Valuation-Informed Indexers, you can never have another bull market. Which means you can never have another bear market. Which means that, in all likelihood, you will never again have another economic crisis (all four economic crises that we have seen since 1870 followed on the heels of a runaway bull market in which the P/E10 level reached 25).

    Could I live with a world in which Valuation-Informed Indexers earned only 6.5 percent real but in which stock volatility and economic crises were a thing of the past? I could live with that. This is a case where I would love to see my outsized returns snatched away.

    Learning is a free lunch.

    Valuation-Informed Indexing is an advance in our understanding of how stock investing works. It is a wonderful free lunch. Restoring stability to the market will help even those who elect for whatever reasons not to adopt the strategy. It is a win/win/win/win/win.

    Rob

    • says

      Rob, I’m going to take Shiller’s data and do something with it, don’t worry.  I don’t like the idea of PE10 as much as you since it has too much memory (it’s looking back at the crisis right now, while in 2018 suddenly it will drop wildly?  Doesn’t scratch for me.).  PE10 is somewhere in the 20s now, but PE is around 14.  10 year Treasury yields?  ~ 2%.  The means I’m not as scared about the valuation now as a VII person would be.

      I think there is something out there better than the PE10. 

      See my below comment about the 6.5% return.  It would be less than that – bond yield plus the cost of carry for standing in line behind bonds in the event of liquidation.  Maybe we can compute that number using instruments available now, but I don’t want to try too hard on a Saturday.  I do doubt it’s 6.5% though.

  10. says

    I think there is something out there better than the PE10.
    That could be.

    We are in the early days of this. It could be that people will identify something better.

    Andrew Smithers uses a valuation metric called “Tobin’s Q.” There are smart people who think that is better.

    Rob

  11. says

    Would the markets be more efficient if insider trading was legal for all (rather than just legal for the big fish, as it is today)? That’s an interesting question ;)

    • says

      Oh, you’re opening up quite a can of worms. I actually think that yes, insider trading should be less strict. However, my answer is long enough to mandate a post about it, haha.

  12. says

    I just can’t see the average investor implementing it in an easy way – the average investor is too quick to sell or buy depending on sentiment.
    But we have never tried telling average investors what the research says. What if we did? How can we know that that wouldn’t work until we try it?

    During the Buy-and-Hold years, Wall Street has been spending hundreds of millions in marketing dollars telling people the opposite of what the research says. What if all that money were directed to promoting Valuation-Informed Indexing?

    I think that would make a big difference. I think the problem here is that the marketing dollars are being used to encourage people to do precisely the thing that always destroys stock investors in the long run. I’ve even had people tell me this. I have had people say “everything you say about investing makes perfect sense, but I feel that I have to go with what the experts say, which is the opposite of what you say.” What if the “experts” were reporting accurately what the research says?

    Rob

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