Buy-and-Hold Is Both Intuitive and Counter-Intuitive at the Same Time
I have made it my life’s work to persuade people to question the Buy-and-Hold concept and I have found that it is not an easy job. For most people, Buy-and-Hold sounds right. Most people are not dogmatic. But the core idea of the strategy — that it is not possible to predict future stock prices and that thus market timing is a bad idea — just sounds right. People are willing to entertain questions re the details. But that core principle is lodged deep within our brains.
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Q2 2020 hedge fund letters, conferences and more
Short-Term Timing Doesn’t Work
The most important reason is that anyone who observes the stock market for even a short time can see that short-term timing doesn’t work. Stock prices jump around in crazy ways all the time. People make predictions all the time and those predictions fail all the time. So the point seems pretty well-established — timing is a loser.
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Of course, Valuation-Informed Indexers do not advocate short-term timing. We advocate only long-term timing. We agree with the Buy-and-Holders that it is not possible to know in advance where stock prices will be six months or twelve months from now. Our claim is that it is possible by looking at valuation levels to have a good idea where prices will be 10 years from now or 15 years from now or 20 years from now.
That is an even more counter-intuitive idea than the idea that all forms of market timing work. Once people hear the concession that short-term timing doesn’t work, their minds push “eject” re the entire market timing concept. To engage in market timing, one would need to see into the future. If one could not see into the future well enough to predict where stock prices will be in six months, it seems implausible that one could see into the future well enough to predict where stock prices will be in 10 years. That paradox is probably the biggest hurdle that keeps people from grasping the Valuation-Informed Indexing concept.
I believe that the paradox can be resolved. Shiller’s research shows that stock investing is a highly emotional endeavor, not a purely rational one, as the Buy-and-Holders suppose. If stock investing is an emotional endeavor, we should not expect to be able to engage in short-term timing. Prices jump all over the place in the short term because they are determined by emotions and emotions are unpredictable. In the long-term, however, another factor comes to exert influence on stock prices.
The ultimate purpose of all markets is to get prices right. So in the long-term, there is a strong magnet pulling stock prices in the direction of the fair-value CAPE level (16). The combination of short-term irrationality and long-term rationality (it is rational for prices to be set at fair-value levels) permits predictability. When irrationality pushes prices to very high or very low levels, it is safe to predict a big move in the direction of a CAPE value of 16 over the long term.
Is that so counter-intuitive a belief?
Taking Chances With Highly Counter-Intuitive Ideas
On the surface, it is. People just cannot get it that short-term price movements cannot be known in advance while long-term price movements can be. That seems backwards. And, given that stock investing is a serious matter that affects people’s financial future, they are not inclined to take chances going along with highly counter-intuitive ideas.
My take, though, is that it is even more counter-intuitive to believe that long-term market timing might not work or might not be required for investors seeking to keep their risk profile constant over time. Price discipline is what makes markets work. With the stock market, price discipline is practiced through market timing. We investors have the ability to set stock prices wherever we please. If there were not some penalty for setting prices too high, the market could not function. The penalty for setting prices high now is seeing low returns in the future. Knowing that returns will be low in the future permits market timing.
So believing in market timing is not nearly so counter-intuitive a belief as it seems on first examination. It makes perfect sense that price changes cannot be predicted in the short-term but can be predicted in the long term. The tricky part is that you need to overcome that first impression that this idea of being able to know stock returns in advance is fantastical to come to an understanding that it really makes all the sense in the world. The idea that price discipline is required in the stock market is the most common-sense idea there is. And that’s all that those of us who advocate long-term timing are saying. We are saying that long-term market timing works because long-term market timing is price discipline and price discipline has worked in every market in which it has ever been tried.
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