Benjamin Graham Was Skeptical of One Aspect of Valuation-Informed Indexing
Benjamin Graham was the first Valuation-Informed Indexer. He said in the 1930s that it made sense for investors to go with a 50 percent stock allocation when prices are moderate, with a 25 percent stock allocation when prices are super high and with a 75 percent stock allocation when prices are super low.
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Graham, however, doubted that the majority of investors could ever find appeal in the strategy. He said: “These copybook maxims have always been easy to enunciate and difficult to follow — because they go against that very human nature which produces the excesses of bull and bear markets. It is almost a contradiction in terms to suggest as a feasible policy for the average stock owner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and — this writer believes — we are likely to have them in the future.”
I do not agree.
I certainly understand where Graham is coming from. Stock valuations have been following a roller-coaster pattern for as far back as we have good records of stock prices. Things don’t keep playing out the same way over and over again as the result of coincidence. That roller-coaster pattern reflects something deep in human psychology. We all are drawn to the idea of obtaining something for nothing and the stock market offers an easy means to pulling it off. Push stock prices up to crazy levels and we really do appear for a time to have made ourselves richer. The reality principle ensures that artificially high prices will be followed by artificially low prices when irrational exuberance is transformed into irrational depression. So the pattern repeats over and over again.
But it doesn’t have to be that way.
What the historical record reveals is that there is something in human psychology that makes the repetition of that pattern the default stock investing experience. But another thing that we see over the course of human history is that humans are capable of learning over time and making their lives better by doing so. Someone could have said at one time that women have never been permitted to vote and that therefore we know that they never will be. Or that the percentage of the population that smokes is never going to decline because people will never listen to the warnings about the connection between smoking and lung cancer, Or that humans will never take serious steps to protect the environment. Human life often changes for the better. Sometimes in very big ways.
Irrational Exuberance Gains
I have spoken with tens of thousands of middle-class investors over the past 19 years. It is certainly the case that the majority reacts negatively to the idea that they should not count irrational exuberance gains as real gains. Investors like bull markets. They do not like hearing people tell them that bull markets are dangerous. So the natural state of affairs really is as Graham describes it. It is something deeply embedded in the human psyche that causes both bull and bear markets.
But an affection for the Buy-and-Hold strategy is not all that I have seen over the past 19 years. I have also seen a great respect for the lessons taught by the peer-reviewed research and I think it would be fair to say that the last 40 years of peer-reviewed research shows clearly that strategies that disdain market timing always end in tears. The Buy-and-Holders themselves advocate the use of peer-reviewed research as guidance; they just don’t apply that general rule to the research produced by that Shiller fellow. We did not have 40 years of peer-reviewed research showing us the importance of market timing back in Graham’s day. I don’t think that we can conclude that because investors did not apply the lessons taught by Shiller at a time when those lessons had not become public knowledge that we never will do so.
Not that we are doing any better today. Today’s CAPE value is higher than the CAPE value that brought on the Great Depression. If Shiller’s hope was to teach investors to rein in their Get Rich Quick inclinations, Shiller’s research has been a miserable failure. It pains me to acknowledge that but acknowledge it I must.
But is that because investors are deaf to Shiller’s findings or because Shiller’s findings have not been explained in an effective manner? I very much believe that it is the latter explanation of today’s unfortunate realities that is the proper one.
The vast majority of investors have been tuning out my message for a long, long time. But, as intense as the dislike for the message usually is, that’s how intense the praise for it is among those who are able to hear it. There are lots of people who long to hear about a more sensible, research-based approach to stock investing. My sense is that it is 10 percent of the population of investors that feels that way. Ten percent of the investing population is millions of people. This is a highly lucrative field. So, once investment experts come to believe that there are millions of people who want to hear about more sensible strategies, they are going to be pushing those strategies hard. And we will all be off to the races.
Benjamin Graham’s Perception
It won’t work if the message is pushed in a tentative way. That’s where Graham’s perception is on point. Our natural inclination is to embrace Get Rich Quick strategies. Those of us who make the case for market timing need to be clear just how dangerous it is for investors to stick with the same stock allocation when stock prices have changed dramatically. Milquetoast claims will not make an impression. But clear and firm statements do break through. I have seen it happen on many occasions. And, once the case for valuation-informed market timing clicks for an investor, that investor usually gains increased confidence in the concept with time.
Investors want to do the right thing. They recognize the importance of the investing project. The biggest stumbling block for most investors is that they are intimidated by what they perceive as the complexity of the subject matter. When they hear most experts saying that market timing is not required (or is even a bad thing!) — as they certainly do today — they believe that there must be something to the claim. I believe that the next price crash will cause enough pain that the percentage of experts offering a more realistic long-term take will increase dramatically. When a large percentage of the experts are saying what makes sense, doubts about following a sensible path will dissipate quickly among the majority of average investors.
The intellectual case for valuation-informed strategies is strong. The problem is that, prior to 1981, we did not have peer-reviewed research showing how imperative it is that investors lower their stock allocations when prices get out of hand. And, since 1981, there has been a great reluctance among experts in this field to incorporate the new findings into their understanding of how stock investing works. Once they do, there is no reason to believe that we cannot all quickly become better investors than we have ever been before.
We will still feel that emotional pull to the Get Rich Quick/Buy-and-Hold side of things. But, with good information widely available to us, we will be able to overcome it
Rob’s bio is here.
Updated on Dec 14, 2021, 9:57 am