Looking Forward to the Coming Stock Price Crash

Liberating Stock Price Crash Thought #1 — It’s Virtually Inevitable

I used to worry about the possibility that we will soon see a stock price crash. For obvious reasons. I have lots of friends with high stock allocations. I don’t want to see them hurt.

Stock Price Crash

The first 54 months of The Great Safe Withdrawal Rate Debate have taught me that I was wrong to think that a stock price crash is likely. I now see that it is not just likely, it is all but inevitable.

So I don’t worry about it too much anymore.

Things that are possible or likely generally worry you more than things that are inevitable. Once you come to accept something as inevitable, whatever it is inside you that is in charge of causing you to worry seems to stop pumping out so many worry chemicals into your bloodstream. You no longer direct mental energies to the task of trying to fight off the possibility that is the focus of your concern. You accept what you know is coming. You even start planning for it.

When you accept something as all but inevitable, it’s just not as frightening anymore.

Liberating Stock Price Crash Thought #2 — Avoiding a Price Crash Would Be More Painful Than Enduring One

We are now (this article was written in November 2006) at P/E10 levels nearly double the fair-price P/E10 level of 14. On the three earlier occasions when we ventured into the la-la land where stock prices reside today, we experienced an average price drop of 68 percent. That’s why I say that a price crash appears all but inevitable.

It remains possible to imagine a way to avoid a big price drop, however. What if the scenario that has applied for the past seven years were to extend far into the future? What if the prices of the major stock indexes were to remain at the same general level while inflation ate away at the wealth of those holding shares in those indexes? Isn’t that an alternate means by which stocks could travel the path back to reasonable valuation levels?

I think it is. It has never happened that way before. My sense is that the reason why a stock price crash becomes nearly inevitable when we get to these valuation levels is that even remaining at the same price level for many years eventually causes investors’ confidence in stocks as a long-term investment to falter, and the faltering confidence brings on a big price drop. So I don’t think it is likely that stocks are going to remain dead money for all that much longer. I don’t entirely rule out the possibility, however.

I question, though, whether having stocks remain dead money for long into the future is such a great thing for middle-class investors. Stocks are as a general rule the most powerful wealth-building asset class available to us. We have temporarily lost access to this major wealth-builder. Is that a plus? I sure don’t see how.

The reason why some view the scenario of stocks being dead money for a long time in a positive light is because it appears on the surface to be a more appealing scenario than experiencing a big price drop. A more in-depth analysis suggests quite the opposite. Having stocks remain dead money for many years may well be one of the worst of all possible paths back to reasonable price levels.

Imagine a retiree who retired at age 55 in January 2000, and who placed his confidence in one of the conventional-methodology safe withdrawal rate (SWR) studies in planning his retirement. He determined that he could get by on $40,000 of spending per year, and he retired with a portfolio of $1,000,000 invested 80 percent in S&P stocks. That’s enough, according to many of today’s retirement planning tools. It’s far short, according to the New School SWR studies, which show the SWR at that time for an 80 percent stock allocation to have been 1.6 percent. This retiree is in all likelihood going to experience a busted retirement at some future date, but he doesn’t know it yet.

Which scenario is better for this retiree? One in which he experiences a gut-wrenching price drop early in his poorly planned retirement? Or one in which his portfolio value is slowly eaten away by inflation and in which he learns of the analytical errors of today’s retirement planning tools at some date far off in the future?

When Stock Prices Crash, Where Does the Money Go?

I have come to believe that the latter scenario is in some ways the worst of all possible scenarios. It may be that a stock price crash is just what this retiree needs to wake up to the realities of long-term stock investing at a stage of life in which learning them can still do him some good.

If the Year 2000 retiree holds back from selling stocks until the stock price crash does a good bit of harm to his portfolio value, he will need to return to work. His chances of finding appealing employment are obviously better the earlier in life he comes to terms with the realties.

A stock price crash is going to be painful to those who bought into the bull market illusions that have done so much harm to so many middle-class investors in recent years. The reality, though, is that stretching out the pain does not make it easier to take.

Liberating Stock Price Crash Thought #3 — A Big Price Drop Will Balance the Scales of Justice a Bit

Different types of investors are affected in different ways by wild bull markets and by the wild bear markets that inevitably follow them. There has never been a better time in the history of the United States to begin investing heavily in stocks than in the early 1980s. There has never been a worse time in the history of the United States to begin investing heavily in stocks than in the late 1990s and the early 2000s.

Were the investors who began investing heavily in stocks in the early 1980s all incredibly smart people? Not really. Were the investors who began investing heavily in stocks in the late 1990s and in the early 2000s incredibly dumb people? I sure don’t think so.

Many of those who think of themselves as smart because they received outsized investment returns as the result of buying stocks in the early years of the most wild bull market ever were just lucky to have been born at a time that positioned them to be starting to earn nice incomes at the start of the 1980s. Many of those who in future years will come to think of themselves as dumb because they were taken in by the bull market illusions just before the wild bull was about to be replaced by an equally wild bear were just unlucky to have been born at a time that positioned them to be learning about how to invest at a time when the nonsense quotient in the investment advice offered by the most popular experts was at the highest level it has ever been.

There is nothing we can do to change the reality that the fates smile on some of us more than they do on others. As Paul Simon once observed in song: “Some folks portfolio values grow steadily, some folks portfolio values, they never grow at all — they just fall.” As the Bible tells us, those who started buying stocks near the tail end of a huge bull market will be with us always.

That said, it will be better for those who began investing in recent years if prices someday soon fall to a point where it becomes reasonable once again to look forward to exciting long-term returns from stocks. William Bernstein has reported that, in the event that stock prices remain at today’s levels for some time to come, the expected long-term return on stocks drops to 3.5 percent, about half of what it has been throughout the history of the U.S. market. Not good.

How can we overcome Bernstein’s dire prediction of poor long-term stock returns for years and years to come? By experiencing a healthy drop in stock prices. Bernstein isn’t predicting poor stock returns for as far into the future as the eye can see because something has happened to the U.S. economy making it far less productive than it has ever been before. He just understands that the weight of today’s la-la land stock prices is more than even the strongest economy in the world can overcome.

Stocks in the News

The medicine that my boy needs to take to get over his recent illness doesn’t taste good. But the results are sure nice to contemplate — a four-year-old once again running and jumping and playing and singing the way God intended. A stock price crash isn’t going to go down too easy either. In the long run, though, it will prove to be a good thing for those of us who were unfortunate enough to have become able to invest just at the time when the best investment class of all became so overpriced that it could no longer realistically promise the sorts of returns that it has provided through most of the history of the U.S. stock market.

Liberating Stock Price Crash Thought #4 — We Need to Get to Work Developing the Insights of the Past 54 Months

The Financial Freedom Community has done extraordinary work over the course of the past 54 months. I think it would be fair to describe the insights developed during the early chapters of The Great Safe Withdrawal Rate Debate as the most far-reaching insights ever developed by any internet discussion-board community.

Those insights have not yet been developed to the extent they need to be developed. We have had hundreds of community members putting forward exciting contributions. We have also had hundreds throwing obstacles in our path. And we have had hundreds leaving the community in revulsion over the tactics employed by those trying to find a way back to the Summer of 1999. The Campaign of Terror has hurt us big time. It’s been a stone cold drag.

All that comes to an end when we experience a stock price crash.

Will it hurt? Yes, it will hurt. Will we look back years later and conclude that the pain experienced in becoming able to push our Learning Together project into overdrive was worth it ten times over? That’s what I think is going to happen.

There are all sorts of exciting things that become possible in our community once the nonsense from the Summer of 1999 is finally laid to rest. The nonsense from the Summer of 1999 is getting old, real old. Truth be told, the nonsense from the Summer of 1999 has gotten so old that it is beginning to stink. Let’s move on.

Liberating Stock Price Crash Thought #5 — We Need to Learn How to Talk Sensibly About Stocks Again

I’m not a fan of huge bull markets or the huge bear markets that follow them. When I invest, I am putting my money at risk. I aim to be as calm and rational as possible when my money is at risk. Both huge bull markets and huge bear markets are times when rationality is lost in the wind and out-of-control emotions rule the day.

The intensity of the emotions we have seen in investors hoping that Bull Market prices can remain in place a few years longer is embarrassing to those of us who seek to plan for early retirement in a sober and serious and realistic way. It puts humans in a negative light to see them give in to feelings of greed and fear, the dominant investor emotions in out-of-control markets.

Defensive Investing Strategies
I believe that the times when investors learn the most about how to invest effectively for the long run are those sweet stretches of time when investor emotions are not so out-of-control. I like moderate prices not only because moderate prices provide the best returns for investors (stocks can generate a real return of 6.5 percent per year without valuations ever going above fair-value levels) but also because moderate returns provide the environment for the investors themselves to be smarter and kinder and more responsible and more caring (both to themselves and to their loved ones and to their fellow investors).

We are better people when the fear of returning to reasonable prices is not eating away at our insides. A stock price crash wouldn’t just be good news for most of us financially. It would be good news for most of us on a human level too.

That’s what counts the most, isn’t it?

It’s not just about being rich. It’s about feeling rich. So long as the prospect of seeing the inevitable stock price crash take place remains hanging over our heads, we are not going to be able to feel good about our investing lives. Once it actually takes place, the fear is gone. The stock price crash will set us free!

Let’s stop being frightened of the big price drop to come. Let’s invite it into our lives. Let’s welcome it. Let’s look forward to it. Let’s make plans to enjoy it when it comes.

I’m praying for a stock price crash, you know? I’m not praying that it come too soon, however. It would be nice to finish my book on investing first. Saint Augustine once implored his Maker: “Lord, please make me chaste — but not just yet!” So let it be with a stock price crash. Bring those prices down hard and do it soon, Dear God, but let this poor boy get the words written that he needs to get written in time to make some personal hay from all this nonsense too.

Is that so much to ask?

The Coming Revolution in Stock Market Investing Advice

The usual stock market investing advice of today is rooted in a false understanding of what the historical stock-return data says about investing for the long-term. Andrew Smithers (co-author of

The Coming Revolution in Stock Market Investing Advice

Valuing Wall Street: Protecting Wealth in Turbulent Markets) predicts that we soon will see a “revolution” in the accepted thinking of how stocks perform in the long run. I think he’s right.
Set forth below are five reasons why I believe that the conventional stock market investing advice must soon change.

The first reason why the conventional stock market investing advice must change is that stocks are NOT always the best investment class for the long run.

You have no doubt heard that stocks are the best investment class for the long run. This claim is rooted in flawed understanding of the message of the historical stock-return data.

The big downside of stocks is their volatility. The “Stocks for the Long Run” argument is that volatility doesn’t really matter so much to the long-term buy-and-hold investor. Sure, stock prices may go dramatically down for a time. But, historically, they have always come back up in time. So, the argument goes, the buy-and-hold investor need not worry about volatility too much.

It’s a powerful insight. It really is true that buy-and-hold investors can provide for themselves a good bit of protection from volatility by investing for the long-term.

This protection is not nearly as complete as most stock investors of today think it is, however. There is a second message in the historical data that argues against going with too high an allocation in stocks at times of high valuation–the tendency of stocks to snap back from price drops is greatly diminished at times of high valuation.

The historical data shows that stocks do not perform the same starting from times of low valuation, moderate valuation and high valuation. Anything can happen in the short-term for stocks purchased at any valuation level. But the really bad long-term price drops almost always take place at times of high valuation. Following a buy-and-hold strategy helps you deal with the curse of volatility, but it helps a lot less at times of high valuation than it does at times of low or moderate valuation.

Does this mean that you should avoid stocks at times of high valuation? By no means. But the historical data does indicate that it is a mistake to ignore the valuation factor when deciding on how high a percentage of your portfolio to invest in stocks.

Horserace Between Buy-and-Hold and Valuation-Informed Indexing

Go with a high stock allocation at times of low or moderate valuations, and you will probably do not too badly so long as you follow a buy-and-hold approach. Go with a high allocation to stocks at a time of high valuation, and you may experience so crushing a blow to your portfolio that you will find it impossible to maintain that high stock allocation for as long as you intended.

The second reason why the conventional stock market investing advice must change is that market timing works.

That’s a radical claim, isn’t it? If there is one piece of investing wisdom that has been drilled into our heads over the past 20 years, it is that attempting to time the market is a loser’s game. Again, that’s partly true but also partly untrue. The conventional stock market investing advice needs to change to facilitate an appreciation of not only the part that is true but also of the the part that is untrue.

There is good reason for believing that short-term timing does not work. Perhaps it works in rare cases, but it is an investing trick so hard to pull off that most middle-class investors would be better off directing their energies elsewhere. So the conventional stock market investing advice has steered us well in steering us away from any temptations to engage in short-term market timing.

Long-term timing does work, however. And long-term timing presents us with wonderful opportunities for avoiding the losses that can be suffered by over-investing in stocks at times of high valuation and thereby preserving the capital needed to participate more fully in the more appealing long-term returns earned by those who purchase stocks at times of low and moderate valuations.

Why do I say that long-term timing works? Because the historical stock-return data shows it to be so. Here’s what William Bernstein, author of The Four Pillars of Investing, says on Page 55 of that book: “Think about it, which would you rather know: the market return for the next six months, or for the next 30 years? I don’t know about you, but I’d much rather know the latter. And, within a reasonable margin or error, you can.”

I’ll bet you didn’t know that. Most middle-class investors of today do not. That’s because the conventional stock market investing advice has steered them wrong. The conventional stock market investing advice has been so focused on warning us not to engage in short-term timing that it has failed to point out the great efficacy and value of long-term timing. But it is as important to be aware of the benefits of long-term timing as it is to be aware of the dangers of short-term timing.

When I tell people what the historical stock-return data says about the effects of valuations and the efficacy of long-term timing, a frequently heard response is that stock returns are highly unpredictable and that knowing what sorts of returns stocks are likely to provide in 20 or 30 or 40 years requires the use of a crystal ball or consultation with a fortune teller. It’s not so.

Buy-and-Hold Is Dead

Long-term stock returns are pretty darn predictable. They are by no means perfectly predictable. But the reality is that in many different time periods in U.S. history, U.S. businesses have provided surprisingly similar long-term returns. You can’t predict how any one company will perform, of course. But, if you purchase shares in a broad stock index, you are not buying a share in any one business but in all the businesses that make up the index. So long as the U.S. economy remains as productive as it has been in the past, you can possess on the day of purchase a good sense of what sorts of economic returns the asset you purchase will be generating over the long term.

Be careful now. I am not saying that those purchasing an index fund will obtain long-term returns reflective of the long-term gains generated by the companies in the index. That will be so for those paying a fair price for the shares. Those paying a good bit less than than a fair price will obtain even juicier long-term returns. Those paying a good bit more than a fair price will obtain less satisfying long-term returns. The point is, if U.S. businesses continue to perform in the future much as they have in the past, index investors can do a good job of estimating their long-term returns by making an adjustment for the effect of the valuation level at which they purchased their shares.

The idea seems to have taken hold that stocks are essentially lottery tickets. That’s what people are suggesting when they argue that long-term returns are entirely unpredictable. The reality is that stocks are shares in businesses. When you purchase an index fund, you are purchasing shares in most of the companies making up the U.S. economy. So long as the U.S. economy continues to perform much as it has in the past, the returns you will obtain on purchases of a broad stock index will be more predictable than you realize from what you have picked up from listening to the conventional stock market investing advice of recent years.

The fourth reason why the conventional stock market investing advice needs to change is that the bull market that gave rise to it appears to be either at an end or near an end.

The exaggeration of the benefits of buying stocks that have dominated the conventional stock market investing advice in recent years is not a new phenomenon. Read investing books from many years back and you will see that there are cycles in the conventional advice that repeat over and over again. In bull markets, the negatives are greatly downplayed. In bear markets, stocks are made out to be the worst investment-class imaginable. It may not be too long before we will be hearing not that stocks are always the best choice for the long run, but that no middle-class investor should ever be invested in stocks at all!

The key to successful long-term investing is ignoring the extremes both of the conventional stock market investing advice of bull markets and of the conventional stock market investing advice of bear markets. The reality is that stocks are a wonderful asset class, but that there is no one asset class that is the one right choice for all times and all circumstances. The successful investor does not permit himself to become too influenced by the overwrought arguments of either the bulls or the bears.

The Shiller Revolution

We saw play out before us the greatest bull market in the history of the U.S. market from the early 1980s through the late 1990s. So we should not be too surprised that the exaggerations of the conventional stock market investing advice have in the past decade reached a level of intensity never experienced before. Those seeking financial freedom early in life cannot afford to focus too much on that sort of thing. We look to the historical stock-return data to temper the temporary enthusiasms that wreck such havoc on the investing dreams of both the extremist bulls and the extremist bears.

It was difficult to question the conventional stock market investing advice in the late 1990s, when stocks were still generating annual double-digit returns for those invested in them. It is still hard to do so today, but my sense is that more and more middle-class investors all the time are becoming open to more tempered and moderate and sensible investing arguments. The great bull has run itself out. We are nearing the day when more investors will be looking in a serious and sober way to learning what the historical stock-return data really says about how to invest successfully for the long run.

The conventional stock market investing advice is rooted in myth. The myths have continued to stand in a wobbly sort of fashion through a time-period of about five years in which gains for those heavily invested in stocks have been less than stellar. I doubt whether the myths driving today’s popular stock market investing advice will be able to withstand too many more years of lackluster performance for stocks. A big price drop would of course lead to an even quicker disenchantment with the usual stock market investing advice of today.

The fifth reason why the conventional stock market investing advice needs to change is that it fails to reflect the difficulty of maintaining a buy-and-hold investing strategy for the long term.

Not all of the stock market investing advice of recent years is bad advice. As noted above, there are powerful insights mixed in with the distortions that are symptomatic of the excessive stock enthusiasm typical of long bull markets. The most important of the genuine insights of the “Stocks for the Long Run” investing paradigm, in my view, is the idea of sticking to one’s stock investing strategy not for one year or three years or five years but for 10 years or 20 years or 30 years or longer. Short-term stock investing is a dangerous business for most middle-class investors seeking financial freedom early in life. Long-term stock investing works.

Unfortunately, the invest-for-the-long-term insight was developed during the greatest bull market of them all, and the enthusiasms of the day caused the insight to be distorted in serious ways. The idea has caught on that, since a great way to reduce the risks of stocks is to hold them for the long term, it is safe to invest all of one’s savings in stocks even at times of extraordinarily high valuations. Nothing could be further from the truth.

New Investing Advice

A buy-and-hold strategy is the way to go. That powerful insight puts on the table the most important and difficult investing strategy question of them all–How high can one go with one’s stock allocation and still hold out reasonable hopes of remaining a buy-and-hold stock investor when stock prices decline dramatically? I think it is fair to say that this question has received far too little consideration during the years in which the stock market investing advice driven by the Stocks-for-the-Long Run paradigm has been dominant.

That needs to change. Most middle-class investors should be aiming to be buy-and-hold investors. But how are they to achieve the goal when the usual stock market investing advice simply presumes the most important element of the strategy? The common thought today seems to be that, if you say that you intend to be a buy-and-hold investor, that will be enough to make you one in the real world. The historical stock-return data argues otherwise.

The buy-and-hold philosophy will likely be tested in years to come, as many middle-class investors become disillusioned with the returns offered by stocks purchased at high prices and determine that there are times when buy-and-hold investing is not nearly so exciting an approach as it has been advertised to be. True buy-and-hold investing really does make sense, however. We need to turn our attention in years to come to learning what it takes to obtain those great long-term returns that the historical data shows are available to those who adopt realistic buy-and-hold strategies.

We will know that we are on the road to seeing that magic happen when we see a general loss of confidence in today’s usual stock market investing advice. The old buy-and-hold is dead. Long live the new buy-and-hold!

Rational Investing vs. Passive Investing

Rational Investing vs. Passive Investing, Comparison #1 — Definition

A regression analysis of the historical stock-return data shows that the most likely 10-year annualized real return for U.S. stocks beginning at the valuation level that applied in 1982 was 17 percent.

Rational Investing

A regression analysis of the historical stock-return data shows that the most likely 10-year annualized real return for U.S. stocks beginning at the valuation level that applied in 2000 was a negative 1 percent.

There is no one stock allocation level that makes sense both at times when the most likely 10-year return is 17 percent and when the most likely 10-year return is a negative 1 percent.

Passive Investing is an approach to investing in which investors stick to a single stock allocation despite dramatic changes in the likely long-term return for stocks. Given that it is impossible for the rational human mind to imagine a logical case that can be put forward in support of this approach, the appeal of Passive Investing must be emotional (it has always been the case that stocks possessed the greatest emotional appeal at times when they offered the weakest long-term value proposition).

Rational Investing is the approach to investing used by those seeking to avoid the influence of the most negative investing emotions and thereby to maximize long-term returns. It is the approach used by those who resist the lure of the Passive Investing concept.

There are many varieties of Rational Investing. Even investors with a vague desire to following Passive Investing principles often incorporate many rational elements into their investing plans.

A desire to invest rationally comes naturally. Passive Investing becomes popular only when stock prices have risen enough to stretch investors’ abilities to maintain control of their most negative emotional impulses to their limits.

Rational Investing vs. Passive Investing, Comparison #2 — Starting Point

You determine at a time when stocks are selling at fair value (a P/E10 value of 14) that the right stock allocation for someone in your circumstances is 60 percent. Over the next five years, the P/E10 value climbs to 20. Do you lower your stock allocation? Or do you let things ride?

This may be the most important decision you will ever face as an investor. Choose to let things ride and you have allowed your unfortunate human attraction to Get Rich Quick schemes to overrule your judgment. Once you do that, it becomes harder and harder to choose the Rational Investing path as times goes on.

But consider what you will be up against. During a time-period when the P/E10 value is rising from 14 to 20, returns are a good bit higher than the 6.5 percent annualized real return that is the norm for the U.S. market. You’ve been enjoying these super returns for five years. And you’re going to lower your stock allocation, give up all this wonderful Money for Nothing just because it’s the rational thing to do? What?! Are you crazy?!

Science of Investing The emotional case is all in favor of Passive Investing.

What’s the case for Rational Investing? That Get Rich Quick schemes never pay off long-term. That the risk of a big price drop is now so high that the potential gains from staying at the same stock allocation don’t justify the potential costs. That the historical data shows that lowering one’s stock allocation in such circumstances has always been the better choice.

I know — that’s all so much blah, blah, blah, blee, blee, blee for so long as prices are rising to ever more unsustainable levels. Emotions are always going to have an influence when it comes time for investors to make stock-allocation decisions and that’s of course particularly so at times of dangerously high prices. Still, I think we need to acknowledge for the record that the Rational Investor would take it the other way. We don’t aim to go on longer trips when gas prices are rising, do we? We don’t aim to stock up on corn flakes when there’s a corn shortage and the price has doubled. Stocks are the only thing we buy for which we pray for rip-off prices to come into effect.

Rational Investing vs. Passive Investing, Comparison #3 — Gaining Experience

The discouraging news is that Rational Investing is hard to choose. The encouraging news is that it is relatively easy to stick with once you choose it.

We all know that the excess returns paid to stock investors during wild bulls isn’t printed up by Milton Bradley. We all have concerns on some level of consciousness that the party is going to come an end and that we are going to get stuck holding the bill. Worrying doesn’t help. Talking about our worries doesn’t help. What helps is doing something constructive — lowering our stock allocations.

You may not see an immediate reward for electing to invest rationally and to lower your stock allocation in response to price increases. Even if you don’t see an immediate financial gain, however, you will feel better about yourself knowing that you have permitted reason to gain the upper hand over your most destructive Get-Rich-Quick emotions. You might doubt yourself from time to time. Probably less often than you might now imagine, however.

For the Passive Investor, things go downhill regardless of whether he sees a short-term financial payoff for investing emotionally or not. If stock prices go down hard, the Passive Investor panics because of the price drop. If stock prices go up, the Passive Investor grows more intensely emotional because he is not able to feel comfort in his irrational decisions. Passive Investing doesn’t work because investors need to be able to stick with a plan for the long-term for it to work and Passive Investors can never possess the level of confidence in their decisions needed to stick with them for the long term.

Rational Investing vs. Passive Investing, Comparison #4 — Learning

Rational Investors are learning investors. One of the scary things about investing is that it is impossible to know all that you need to know when you start. Much of what you learn you must learn from experience. Things obviously should get better over time. For Rational Investors, they do.

How to Invest It’s not so for Passive Investors. Passive Investing is a dogmatic approach. That’s so by definition. The very appeal of Passive Investing is that it is a non-thinking approach; it’s not possible to effectively question an emotion, so Passive Investors see their choices as being beyond question. The emotional appeal of the Get Rich Quick scheme causes investors to want to try Passive Investing, and their desire for rationalizations to support their decision creates a market for “experts” to come up with some. But none of the rationalizations can stand up to logical scrutiny.

The result is that the Passive Investor dares not become more knowledgeable as time goes on. The most fundamental investing issue is the determination of one’s stock allocation. The Passive Investor’s mind is closed on this topic on the first day. And the process of choosing a stock allocation is so fundamental to the success of the investing project that the Passive Investor cannot open his mind to new ideas without putting his entire belief system into doubt. How can a learning experience take place in such circumstances?

A non-thinking approach can under stress easily be transformed into an anti-thinking approach. Passive Investors start out behind Rational Investors and then fall farther and farther behind as time goes on.

Rational Investing vs. Passive Investing, Comparison #5 — Strategy

Rational Investors have all sorts of strategy questions to consider. Is it best to stick with indexing or should the investor move to picking individual securities as she becomes more knowledgeable? How important is it to shift from a focus on U.S. stocks to global investing? How is successful investing different for those in the distribution stage (retirement) of the investing life cycle from those in the accumulation stage of the investing life cycle? Is it only those near retirement who need to be concerned about big losses or should avoiding big losses be a big consideration even for young investors?

None of these questions make any sense for the investor who has chosen the 100 percent emotional path. There are few strategic problems that can be addressed by those unwilling to make adjustments in their stock portfolios. Passive Investors give away all of their most important tools for making sense of the investing project prior to putting forward any serious effort to figure it out.

Rational Investing vs. Passive Investing, Comparison #6 — Risk

Rational Investors understand both the good and bad side to risk. They are willing to take on risk, but insist on being compensated with higher returns for doing so. Thus, they seek out investment classes that provide a high return to investors taking on moderate levels of risk while disdaining asset classes that require investors to take on extreme levels of risk in exchange for little in the way of potential gains.

How Investing Works

Passive Investors are extremely uncomfortable with informed discussions of risk. For Passive Investors, risk decisions are properly emotional decisions. They see great appeal in high-risk/low-return asset classes; it is during times of high stock prices that Passive Investing inevitably becomes extremely popular for a time. They have contempt for asset classes that offer great returns at minimal risk. At the height of popularity of the Passive Investing approach, Treasury Inflation Protected Securities (TIPS), a risk-free asset class, were paying a guaranteed return five full percentage points higher than the most likely 10-year return for stocks. Passive Investors dismissed anyone seeing merit in TIPS at the time as mentally disturbed.

The risks that alarm Passive Investors are risks to their fragile “understanding” of how stock investing works in the real world. Passive Investors seek to avoid consideration of the realities of risk under the thinking that risks that they are not informed about cannot hurt them. The historical stock-return data offers zero support for this “theory.”

Rational Investing vs. Passive Investing, Comparison #7 — Conflict

Conflict between Rational Investors and Passive Investors is inevitable if they attempt to engage in discussions of their respective approaches.

The root problem is that the two groups of investors are proceeding from entirely different premises. Rational investors are seeking to maximize the return on their investments. The election to pursue Passive Investing is an election not to seek to maximize returns. The very idea behind the Passive Investing approach is to keep at bay facts and data that would cause emotional anguish for those pursuing fantasy approaches.

The first inclination of Rational Investors is to look for reasons for various possible options. The first inclination of Passive Investors is to respond to the discussion of reasons with anger. Reason and emotion speak different languages and so it is all but impossible for investors in the different camps to communicate with each other.

The reality, of course, is that many investors who identify themselves as Passive Investors in fact feel little commitment to the approach. Passive Investing is an idea that becomes popular in runaway bull markets, which always attract many people with little interest in stocks to participation in the market. A good number of these will describe themselves as “Passive Investors” so long as that remains a popular sort of investing, but will abandon this “philosophy” when its downside becomes obvious. Some of these investors will abandon stock investing altogether as a result of their bad experience. Others will open themselves to consideration of more effective approaches and in time will become highly rational investors.

Keeping Your Sanity re Investing Only the most dogmatic of Passive Investors are truly beyond the reach of human reason. Unfortunately, it is the purists who possess the most influential voices in the Passive Investing camp.

Rational Investing vs. Passive Investing, Comparison #8 — Buy-and-Hold

Passive Investors often claim to be long-term buy-and-hold investors. It seems highly unlikely, however, that many Passive Investors will be able to stick to buy-and-hold once it is put to its first significant real-world test.

Passive Investing is blind investing. Since Passive Investors don’t change their stock allocations in response to price changes, most don’t bother to learn much about the effect of valuations on long-term returns. In many cases, such learning would bring on feelings of discomfort. So Passive Investors are not able to make much sense of why stock prices sometimes go up for long periods of time and at other times go down for long periods of time.

That ignorance makes the practice of an effective buy-and-hold strategy all but impossible in the real world.

Buy-and-hold is of course effortless during a wild bull or in the early years of the secular bear that follows, when there are still widespread thoughts that the bull is coming back. It is when the bear has been in place for some time that buy-and-hold strategies are tested. It is the Rational Investors who are best positioned to survive the test. A Rational Investor understands why prices are coming down and has lowered his stock allocation to prepare for the price drop. A Passive Investor is mystified as to why stocks are no longer performing as they are “supposed” to.

Rational Investing vs. Passive Investing, Comparison #9 — Emotion

Reason begets reason. Emotion begets emotion.

Rational Investing vs. Buy-and-Hold Passive Investing is rooted in emotion. The investing experience of the Passive Investor becomes more emotional over time as the real world shows an increasing unwillingness to conform to the dictates of the Passive Investing mindset. The real world can be so contrary; I sometimes get the feeling that it just does not care too much what all those Ivory Tower Eggheads say in their papers and studies and books and speeches! The world is not passive. The market is not passive. Reason is not passive. It is only the Passive Investors who are passive. As awareness of the disconnect dawns, we see dismay and shock and defensiveness and anger.

Rational Investors fall prey to negative investing emotions too, of course. The difference is that investors who struggle to overcome their negative emotions become increasingly confident over time in their ability to do so.

I got out of stocks in 1996. In 1997, 1998, and 1999, stock prices shot up dramatically. I had a few moments of weakness when I had to review the historical data to confirm that what I had seen on earlier surveys really was there. I rarely experience these sorts of doubts today. I have been following the Rational Investing approach (changing one’s stock allocation in response to dramatic price changes) for long enough now (this article was posted in April 2008) and have seen it tested in a sufficient number of different environments that my confidence in it is much stronger. I don’t say that I will never again experience doubts. I believe that I will. I also believe, though, that my greater confidence is here to stay. I will have a greater ability to cope with those doubts because of what I have learned by following the Rational Investing course for over 10 years now.

Passive Investing starts out bad and gets worse. Rational Investing starts out good and gets better.

Rational Investing vs. Passive Investing, Comparison #10 — Other Investing Approaches

There are many rational investing approaches. There are things that we can learn from investors using fundamental analysis, and from investors using technical analysis, and from investors following momentum strategies, and from investors following contrarian strategies, and so on. Rational Investors are open to all these learning experiences. Whatever helps us earn enhanced returns is seen as a good.

Rational Investing Is Emotional Healthy Investing

It’s not so with Passive Investors. Because Passive Investing is an artificial construct (there is no possible rationale for investing passively — the entire investing approach is one constructed to justify the urge to give in to a Get Rich Quick impulse), Passive Investors tend to be highly defensive investors. They compensate for the irrationality of their approach by declaring it not only a rational approach, but the only rational approach. Declaring one approach the only rational approach of course closes the option of learning from all the other approaches developed by all the millions of other smart people in the world.

To embrace Passive Investing is to reject your capacity to engage in human reason. Don’t go there! Your need to justify to yourself your decision to reject your own capacity to reason will cause you also to reject the product of the reasoning power of millions of other investors traveling different paths to solve the same mysteries.

Passive Investing is a lose/lose/lose proposition. It’s not just that it leaves you financially poor. What’s worse is that Passive Investing is a way of thinking about the investing project that in time leaves the investor incapable of engaging in the intellectual work necessary to have any realistic hope of becoming a successful long-term investor.

Passive Investing — Bah!

Rational Investing is the Dr. Pepper approach.

I’m a Rational Investor! He’s a Rational Investor! She’s a Rational Investor! We’re all Rational Investors!

Wouldn’t you like to be a Rational Investor too?

If the Random Walk Is Real, The Efficient Market Isn’t

If the Random Walk Is Real, the Efficient Market Isn’t.

People who believe in an efficient market generally also believe that stock prices follow a random walk. It can hardly be that both concepts apply (at least not at the same time), can it? These are opposite sorts of phenomena.

Random Walk An efficient market is one in which prices are in some important sense “right.” For prices to be right, they would need to be set by some rational process. Things set by a rational process are not random; they are predictable.

Mathematics is rational. The results of mathematical calculations are not random.

If you are trying to drive your car in such a way as to make efficient use of your fuel, you do not choose your driving speeds randomly; you choose them by a rational process telling you what speed generates the best results in various sets of circumstances.

Random prices are unpredictable prices. A market in which prices follow a random walk is an irrational market, an inefficient market.

The results of pure gambling (gambling in which the odds are not tilted to favor the house) are random. The results of a coin flip are random. There is no rational process that can be said to be determing the results of a series of coin flips. Coin flipping cannot be said to be an “efficient” phenomena.

Random Walk Proponents Have Failed to Specify the Time-Period in Which It Applies.

It appears that the confusion stems from a failure of the adherents of the two theories to specify the time-period to which they are referring when they make their claims. There are indeed circumstances in which stock prices appear to follow a random walk. There are also circumstances in which the efficient market theory appears to apply. Stocks are the Certs of InvestoWorld; they are two, two, two investment classes in one!

Stocks follow a random walk in the short term (time-periods of less than 10 years). The efficient market theory applies for time-periods of greater than 30 years. During the time-period in which prices follow a random walk, the efficient market theory does not apply. During the time-period in which the efficient market theory applies, prices do not follow a random walk.

There is a sense in which the claim made in the headline of this article is not true. Both the random walk and the efficient market are real. But both cannot ever be real at the same time, as is suggested by adherents of the ideas as they are usually formulated. The random walk is real only in the short term and the efficient market is real only in the very distant long-term.

Random Walk Proponents Do Not Understand Its Cause.

Burton Malkiel, author of A Random Walk Down Wall Street, does not appear to possess a good understanding of what causes the random walk. He has said: “It’s not that stock prices are capricious. It’s that the news is capricious.”

The suggestion is that it is news events that cause price changes. This claim brings to light another conflict in the thinking of random walk/efficient market proponents. Proponents of these theories often argue that investors should tune out the “noise” of reports of investing news developments, that it is only the distant long-term that matters. In the distant long-term, U.S. stock-market returns have been remarkably stable for a long, long time. U.S. stocks reliably provide a distant long-term annualized real return of about 6.5 percent.

If the Random Walk Is Real, the Efficient Market Isn't

I agree that it is the long-term that matters. I question whether Malkiel and others who argue that it is news developments affecting stock prices in the short run understand the implications of believing that it is the long-term that matters. If rational investors know that it is the long-term that matters, why would rational investors care about news developments that only affect short-term prices? News is noise.

There have of course been many news events that have transpired over all of the many time-periods in which the 6.5 percent return has applied. None of them seems to have left much of a mark. What seems to be the driver of stock prices in the very distant long-term is the productivity of the economy in which the underlying companies operate. The U.S. economy has long remained sufficiently productive to support a 6.5 percent annualized real return. So that’s the return we have seen, news developments be darned.

If the short-term price doesn’t matter, and news developments affect only the short-term price, then news development don’t matter either. Do they? News developments are really of interest only to short-term investors, gamblers, irrational investors, emotional investors.

I think that Malkiel would have been more on the mark had he said that it’s emotions that are capricious. Stock prices jump up and down in crazy ways in the short term; that much is so. But it’s not because news developments are unpredictable that short-term prices changes are unpredictable. It’s because investor emotions are unpredictable that short-term price changes are unpredictable.

If all investors were rational, few would even follow news developments from an investing standpoint. Except for a few exceptions (news developments that have a permanent effect on the productivity of the overall economy obviously do matter because they affect the continued viability of the 6.5 percent return), news developments just do not matter. Market prices are random and unpredictable in the short term because investor emotions are random and unpredictable.

News can cause shifts in investor emotions, of course; so news is not entirely lacking in influence on stock prices. It is the emotional reaction to news events that is the driver, however, not the news events themselves. If it is emotions that matter in the short term rather than news, the effect of news events is highly unpredictable. Good news can cause bad emotional reactions. Unimportant news can cause big swings in emotion. Emotions are irrational. Anyone who has ever gotten angry with a loved one for some meaningless and unintended slight (and that’s the entire population of humans who have loved) knows this.

Malkiel is suggesting that the market can be said to be efficient even in the short term because it is rationally responding to news developments. I am saying instead that the market is inefficient in the short term because it is emotionally responding to news developments. We agree that a random walk applies in the short term, but we come to this conclusion for very different reasons.

Short-term prices are capricious, Burton!

The Random Walk Does Not Apply in the Long Term.

Understanding the true cause of the random walk is important.

If you believe as Malkiel does that the random walk applies in the short term because the market responds rationally to news developments, you could be led to believe that long-term prices are set by the same process. As time goes on, the market just continues taking in information bits, continues behaving rationally, continues walking randomly.

I say “no.”

Why? Because the historical stock-return data shows us that stock prices are not random in the long term. Please take a look at the Stock-Return Predictor (see tab at left). The calculator reveals a strong correlation between valuation levels and long-term returns. If prices followed a random walk even in the long term, there would not be such a correlation. If prices followed a random walk even in the long term, prices could end up anywhere in the long term. Yet they never do!

What’s going on?

If the Random Walk Is Real, the Efficient Market Isn't What’s going on, I believe, is that the influence of emotion is weakening as the time-period being examined grows longer. It’s only in the short term that investor emotion is the dominant influence on stock prices. As time stretches out, the economic realities become dominant. The market becomes more efficient and prices become less random.

It Is Important to Know the True Cause of the Random Walk.

There are important strategic implications that follow from a conclusion that it is Malkiel’s understanding of the random walk that is correct or my understanding of the random walk that is correct. If my understanding is correct, stock prices will almost certainly return to fair-value levels in time (this article was posted in December 2007). If Malkiel’s understanding is correct, it is at least theoretically possible that prices could remain at today’s lofty levels indefinitely; all that would be necessary for that to happen would be for us to see an exceptionally long string of positive news events.

My sense is that many of today’s investors follow Malkiel’s view of what causes the random walk. Many seem dubious as to whether long-term prices can be effectively predicted, possibly because they do not see how long-term news events can be effectively predicted.

However, if my understanding of why a random walk applies in the short term is correct, there is no need to be able to predict news events to be able to predict stock prices. In my model, news events do not matter. It is the gradual diminishment of the influence of emotions that causes stock prices to return to reasonable levels. Under my understanding of how stock investing works, the gradual diminishment in the role of emotions in setting prices is something that always happens and something that always must happen.

News events often trigger emotional reactions, to be sure. Emotions change because reality intrudes on our fantasy worlds through a string of unsettling or disturbing or unanticipated news events. It is not right to identify the news events as the primary cause of the change in prices that follows, however. News events are only a secondary cause. When prices get far out of line with the economic realities, adjustments are inevitable. News events can affect how soon adjustments take place; they cannot affect whether or not adjustments take place. The cause of price changes is the need for stock prices over time to reflect the economic realities.

An investor who placed his trust in the Malkiel model might decide to remain highly invested in stocks even at today’s prices on grounds that “you never can tell.” An investor who believed in the Bennett model would be foolhardy not to make some downward adjustment in his stock allocation when the price got as out of whack as it is today. Under my model, some sort of price adjustment is all but inevitable.

Under my model, there is no amount of “good news” that can stop stock prices from falling at some point; it is the clash between short-term emotional rationalizations and long-term economic realities that causes the gradual shift from a random walk to an efficient market. At some point, the emotional strains caused by the disconnect between market prices and the economic realities grow so great that investors interpret even nominally good news as bad news for stock prices. Dishonest prices (all bull markets are fundamentally dishonest) cause so many economic distortions that they are unsustainable for more than 10 years (or at least this has always been the case in the market history available to us today).

Picking Stocks Successfully Stocks are held by humans and stock prices are set by humans. So we need to look to human behavior for clues to understanding how stock-return patterns play out. Alcoholism is an act of dishonesty. Do alcoholics find their way back to the reality principle by means of an “efficient” or rational process? They do not. An alcoholic can be threatened with the loss of his family, his job and his health and yet fail to respond to pleas to change. Then he will read a letter from his daughter about the joy she is finding in studying a course that he too enjoyed in his college days and all will suddenly be made clear to him. Humans are not rational. They’re human!

Humans do not turn into entirely different sorts of beings when they come to own stocks. The false confidence in our financial futures brought on by bull markets causes acts of dishonesty as doomed and determined as the false confidence in our personal lives brought on by drink. Investors return to normalcy though a process not dissimilar to the process by which their fellow humans recover from the other form of drunkenness. We do it by fits and starts. For years we turn away from the rational case made by the historical record of stock performance through the years. Then one day we become sick of our own lies and our hearts are turned. It is not news events that cause price changes in the short-term. It is shifts in mood caused by — only the Shadow knows the strange twists and turns that cause human hearts to change.

There are Two Random Walk Models — A News-Driven Model and an Emotion-Driven Model.

The Malkiel model of the random walk and the Bennett model of the random walk are very different models. Although Malkiel argues that investors should ignore the short-term “noise,” he places more importance on news developments than I do. My experience is that even investors who say that they “do not know and do not care” how stocks will do in the short term often take comfort in Malkiel’s idea that it is news developments that cause price changes. Why? I think it is because the idea that news developments are significant gives stock-drunk investors a rationalization for ignoring the strong message of the historical stock-return data — that stock allocations must be lowered when prices reach the sorts of la-la land levels that apply today.

Under my model, investors betting that valuations will not come down are like gamblers kidding themselves into thinking that because it is possible to beat the house in 20 pulls of a slot machine it is also possible to beat the house in 2,000 pulls. We all understand that the longer a gambler continues pulling a slot machine lever, the greater grows the edge possessed by the house. I say that the laws of probabilities apply in the same way for stock investors. It is possible for an investor who ignores valuations to remain ahead for three years or five years or even 10 years. After 10 years, the odds become incredibly long against that continuing to remain the case. Eventually, the laws of probability catch up to the investor who insists on betting against the house.

If you understand why the house stands a good chance of losing to a gambler who makes only a few pulls of the lever but is virtually certain to end up ahead of a gambler who makes 2,000 pulls, you will be close to understanding the terrible mistake that adherents of the random walk and the efficient market have made in developing their model of how stock investing works. The reason why the house is almost certain to be ahead after a large number of pulls is that it takes time for the laws of probabilities to come to dominate results. The probabilities always favor the valuation-informed investor. But the probabilities can be beaten for one year or three years or five years.

Can the probabilities be beaten for 10 years? Anything can happen in this crazy old mixed-up world of ours. I sure would not want to be betting my retirement money on that long-shot bet coming through for me, however. I want the probabilities on my side in the long run.

Those Who Believe in a Long-Term Random Walk Misunderstand How Risk Is Rewarded.

The Efficient Market Theory has sprung a lot of leaks in recent decades. The historical data simply does not support today’s dominant investing model. However, its proponents have been reluctant to cry “uncle!” They continue to believe that they will come up with some way to square this theory with the facts. I see this as a futile quest.

Case Against the Random Walk Theory

When evidence is put forward that investors who make intelligent choices are able to do better than those who do not (this would not be possible if the market really were efficient), the standard response of Efficient Market Theory proponents is that those investors must be taking on more risk (if they earned greater returns as compensation for taking on more risk, that would not violate the rules of “efficiency”). The obvious problem with this argument is that it renders the theory untestable. If all evidence that the market is inefficient is dismissed as a case where more risk applied (but did not cause unappealing results), there is no way ever to disprove this theory. Theories that cannot be disproven are not the products of scientific investigation; they are mere unproven assumptions.

Again, what’s really going on here?

Just as the random walk enthusiasts fail to distinguish the influence of news developments from the influence of investor emotion, the efficient market enthusiasts fail to distinguish different types of risk. It is probably true that risk is related to return in some ways, but I do not see any evidence that this is so in the way in which the theory’s proponents claim it is.

The theory’s proponents fail to distinguish real risk from perceived risk. Investors often fail to properly assess the risk associated with stock investing. The Return Predictor shows that the risk of stock investing has been sky high in recent years while the likely long-term return for stocks has been a good bit lower than what can be obtained from far safer asset classes.

Efficient market enthusiasts dismiss today’s reality as a logical impossibility. They imagine a law of the universe that ensures that stock investors always be rewarded for taking on extra risk. The reality (as seen from my perspective, of course) is that investors are often compensated not for real risk but for perceived risk. When stock prices are high and risk is high, stock investors receive no compensation for taking on risk because they do not demand any (stock investors are generally most complacent about risk when prices are high and risk is great). When stock prices are low and risk is low, stock investors receive an extraordinary amount of compensation for the little risk they take on (stock investors are generally unwilling to consider stocks when prices are low and can only be enticed to test the waters by the promise of long-term returns far in excess of what stocks provide at times of normal prices).

The Most Important Time-Period for Investors Is the Time-Period In Which the Random Walk Is Being Transformed Into an Efficient Market.

Both the random walk and the efficient market are important concepts. We have learned much from the work done by Burton Malkiel and Eugene Fama and their many supporters. Unfortunately, their failure to specify the time-periods in which the two conflicting models for understanding how stock investing works apply threatens to bring about a wipe-out of middle-class wealth in days to come.

Problems with Random Walk Concept Most of today’s investors seem to believe that it is possible for there to be both a random walk and an efficient market at the same time. I sure do not see how. If you are able to make sense of claims that both concepts can apply at the same time, I would be grateful if you would drop me an e-mail letting me know your thinking. The question I need answered is — If the market is efficient even in the short-term, why is it that investors who change their stock allocations in response to price swings are able to gain a long-term edge?

If I am right that the two concepts apply at different time-periods, then the next logical step in our effort to come to a realistic understanding of how stock investing works is to focus on the time-period from 10 years out until about 30 years out. We know how stocks perform after the passage of 30 years (there has been much written on the efficient market theory). And we know how stocks perform in the short term (there’s been much written about the random walk). We know little about the all-important time-period that stretches from Year 10 to Year 30.

Those years are the years most important for the middle-class investor. It is how a middle-class investor’s portfolio performs in those years that determines whether he will be able to walk the buy-and-hold walk as well as to talk the buy-and-hold talk. Please take a look at the three calculators now available at this site (The Stock-Return Predictor, The Retirement Risk Evaluator, and The Investor’s Scenario Surfer) for an overview of the work that I have done with John Walter Russell to begin to provide investors a sense of what sorts of investing strategies those seeking financial freedom early in life need to be following in this all-important-but-as-of-yet-rarely-examined time-period.


Pros and Cons of Index Investing

Set forth below are five reasons why I like index investing and five reasons why I don’t (at least not as it is generally practiced today).

The first thing I like about index investing is that it greatly simplifies investing.

Index Indexing Pros and Cons

When you buy shares in an index fund rather than purchasing individual stocks or buying shares in a mutual fund, you don’t have to do much research because you are electing to participate in the gains earned by all the companies whose shares are in the index rather than to try to pick the winners. Time is precious to today’s middle-class worker. An investing approach that saves us time by simplifying the process by which we make investment decisions thereby provides us with a significant benefit.

The second thing I like about index investing is that it protects me from making big mistakes.

I believe that it is possible by engaging in extensive research to pick stocks that do better than average and thereby to earn better-than-average investing returns. I see a significant risk in trying to do that, however. I don’t spend all the hours of my days studying investments. So there is a chance that, if I relied on my own research in picking stocks or funds, I would fail to consider something important. That could cost me a lot of money.

With index investing, that can’t happen. I might not earn the highest possible returns. But index investing generally permits me to earn solid returns without taking on risks that I prefer not to take on.

The third thing I like about index investing is that it is an approach to investing that makes sense.

Index investing is not gimmicky. There are no charts you have to study to be a successful index investor, no patterns you need to uncover. You hand over your money and you obtain a stake in the success of all businesses covered in the index. Index investing is a no-muss/no-fuss approach. It’s a common-sense approach. It’s a get-rich-slow approach. All of that appeals to me.

This is why indexing is supported by some of the greatest minds in the investing field–people like John Bogle, William Bernstein, and Scott Burns. These guys are smart enough to see that you generally don’t need to outsmart the market to do well with your investments, you just need to be part of the market, to participate in the market.

The fourth thing I like about index investing is that it generally provides solid returns.

The first three arguments in favor of index investing wouldn’t count for much if it was required of indexers that they satisfy themselves with paltry returns as the price of enjoying this simple, risk-diminished, sensible approach to investing. But the reality is that indexers often earn highly appealing long-term returns.


The historical annual real return on U.S. stocks is a number close to 7 percent. That’s a mighty attractive return.

If I can obtain 7 percent returns without having to take on significant risks and significant research work, I am inclined to take the deal. It doesn’t seem likely to me that I could reliably obtain returns much higher than that even if I were willing to put a good deal of energy into the task of doing so. If the easy way to invest provides “good enough” returns, it doesn’t make sense to travel the more difficult and uncertain path.

The fifth thing I like about index investing is that it is a humble approach to investing.

Indexers are acknowledging up front that they cannot outsmart everyone else. If they thought they could, they would want to show off their skills by becoming The World’s Greatest Stock Pickers. The humble nature of the index investing project inspires confidence in it.

Remember that Eagles song about what a peaceful, easy feeling it is to have both feet on the ground and thereby to be assured that something you are a bit excited about won’t let you down? Index investing provides that peaceful, easy feeling to those who employ it as their investment approach, and not too many other investing strategies do. That peaceful easy feeling is worth something.

The first thing I don’t like about index investing is that it has become a less humble investing style in recent years.

It’s hard for the successful to stay humble. Success breeds pride. Indexing has been a highly successful investing strategy in recent decades. A good number of indexers have become too proud of their approach, in my view.

Some indexers have begun to think that their approach is too obviously better than all the alternatives and have become rigid in their views of how index investing must be carried out. There is a certain dogmatism in much of what indexers proclaim about their investing strategies today.

Index Fund Investing Pride comes before a fall, and I worry that the success that indexers have experienced in recent years may have fostered an arrogance that will prove to be dangerous to their hopes of long-term investing success.

Indexers are smart investors, as a rule. Perhaps some indexers are too smart. Indexers have enjoyed a nice long ride of success in the U.S. markets, and because their investing approach is one backed by a good number of academic studies, indexers tend to attribute their success to their particular abilities to understand things that those following other investment strategies do not. It could be that index investing has just enjoyed a good run and that the steadfastness of followers of this approach is going to be put to severe tests in years to come.

To the extent that indexers have become hostile to the merits of arguments made by those following other investing approaches, they could bring discredit on the indexing approach in days to come. There is no one perfect investing approach, in my view.

The second thing I don’t like about index investing is that the conventional indexing approach does not permit consideration of the effects of changes in valuation levels.

The price you pay for an asset affects the long-term return you will obtain from investing in it. I don’t see any way around that reality. It is something that must always be true. So I never feel comfortable investing without first checking out whether the thing that I am investing in is undervalued, fairly valued, or over-valued.

Indexing purists do not take the valuation levels of the stock indexes they invest in into account when making their investment decisions. I do not see any reason why indexers could not take valuation into account. The point of indexing is to be sure to earn the returns earned by the market as a whole by investing in the market as a whole rather than in individual companies in it. There is no reason why one could not increase one’s investment in the market as a whole at times of low valuation and decrease it at times of high valuation. In theory, index investing is compatible with valuation-informed investing. In practice, however, many indexers are hostile to the idea of adjusting one’s stock allocation in response to increases and declines in stock prices.

What Is an Index Fund? So the conventional sort of index investing is not for me. The failure to take the effect of valuations into account cancels out many of the things I most like about the indexing approach. Fail to take valuations into account and you incur significant risks of big losses. The great appeal of indexing in my mind is that it provides one with the ability to obtain good returns with ease and by taking on acceptably limited amounts of risk. Ignore valuation, and the potential return drops while the potential loss increases. Not good.

The third thing I don’t like about index investing is that it causes the investor to lose sight of the connection between corporate profits and the investing returns he enjoys.

Investing returns don’t fall from the sky. They have to be earned by the companies in which you are invested. This is an obvious truth when you invest in individual companies. Those who invest in individual stocks often read accounts of new products that their companies are coming out with and plans their companies have to market more effectively, and so on. This is good. Reading about how profits are earned keeps the investor focused on what matters in investing–profits. Profits are what make the investment machinery continue turning around.

Indexers would never explicitly deny the importance of profits. But there is something about index investing that seems to cause some investors at some times to lose sight of the connection between profit-making and investor returns. I often use analyses of how stocks have performed in the past to form assessments of how they are likely to perform in the future. On a number of occasions, I have seen indexers dismiss the significance of the historical stock-return data, arguing that there is no way to know with precision how stocks will perform in the future and therefore it is not worth making use of the data to form any assessments whatsoever. I view this as a dangerous attitude for an investor to take.

The dangerous viewpoint that I am making note of here is not held only by indexers. But my impression is that it is more common among them than it is among investors who invest in individual stocks. I believe that the root of the problem is that indexers operate at one level of abstraction up from where stock pickers operate. Stock pickers must study the underlying companies in making their investment decisions. Indexers don’t need to do this, and often don’t. The result is that they tend to lose sight of some of the basic realities of investing and get caught up in all sorts of ivory-tower mumbo-jumbo jizz-jazz.

Stock Indexes

Academic studies often have great value. Please don’t interpret these words as me giving my endorsement to any sort of Know-Nothing School of Investing. Still, there are solid academic studies that study serious questions in serious ways, and there are silly studies that say things that cannot possibly be so in the real world. My experience is that indexers are more inclined to fall for the nonsense gibberish stuff than are investors who roll up their shirtsleeves and do a little bit of personal investigation of how it is that the companies they are investing in earn their profits.

Index investing is easier because it does not require study of the ins and outs of the companies generating the investment returns. There’s often a price to be paid for taking the easy road. Those making use of index investing need to be especially careful to keep their thinking about what works in investing rooted in real-world considerations. Nice theories backed by nice charts and nice tables and nice rows of numbers don’t pay the electric bill if they are based on silly la-la land assumptions.

The fourth thing that I don’t like about index investing is that it is too mechanical and rigid an investing approach, at least as it is practiced by purists.

I think indexers are on the right track, for the reasons cited above. But I think that it is far too early in the game to be thinking that we have perfected the indexing approach to investing. I like index investing. But I think it can be improved.

Indexing purists argue that investors should follow an indexing approach not just with a portion of their portfolio, but with all of the money they invest in stocks. I’m not so sure. Indexing purists argue that investment advisors can never serve a constructive role. I’m not so sure.

I see some benefits in some circumstances in picking individual stocks. I see some benefits in some circumstances in seeking the advice of an investment advisor. I am uneasy with dogmatic know-it-all pronouncements re what works in investing. I think it makes sense in many circumstances to mix strategies. My view is that dogmatism and investing, like drinking and driving, don’t mix well.

The fifth thing that I don’t like about index investing is that indexing purists place too much stress on numerical calculations and too little on the emotional side of investing.

Most indexers refer to themselves as long-term buy-and-hold investors. History indicates that it is a lot easier to talk the buy-and-hold talk than it is to walk the buy-and-hold walk. I would like to see much more interest among indexers in learning what it takes to become a true buy-and-hold investor.

index fund strategies

My belief is that the key to being a true long-term buy-and-hold investor lies in adjusting one’s stock allocation with changes in valuation levels. Most investors fully intend to follow a buy-and-hold approach when they make their initial portfolio-allocation decisions. Few appreciate how devastating the losses are that historically have been suffered by those who made big bets on stocks at times of high valuations. By lowering your stock allocation a bit at times when the risks of devastating losses are greatest, you protect yourself from the biggest downside of stock investing, and thereby qualify yourself for the stunning long-term returns available to those who invest in such a way as to make their hopes of being proven true buy-and-hold investors realistic ones.

The  emotional aspects of investing in stocks affect the long-term returns obtained. Index investing advocates often give far too little attention to one of the most important questions that middle-class investors need to have answered for them to be able to invest successfully for the long term–“How much should I be lowering my stock allocation at times of high valuation?”

Middle-class workers seeking to win financial freedom early in life should learn about index investing, in my view. I see it as an investing approach with much to offer. That said, I urge against putting too much faith in the sometimes extreme claims put forward by purist indexers. Indexers are smart, but they have not got it all figured out yet by a long shot. Please be especially wary of claims that it is safe to go with high stock allocations at times of high valuations. The historical stock-return data indicates that the risks of investing heavily in stocks at times of high valuations have been greatly understated.

Yes, Virginia, There Is a Free Lunch for Smart Investors

Being afraid I went and hid thy talent in the earth…. And his lord, answering, said to him: “Wicked and slothful servant!”
— Parable of the Talents, Matthew, 25: 14-30.

Life Itself Is a Free Lunch.

There's No Such Thing as a Free Lunch

It has come to my attention that there are noisemakers about disturbing the good people with talk that there is no free lunch. What? No free lunch? That changes everything!

It would change everything if it were so. It isn’t so. Don’t be impressed that there are lots of otherwise smart people who go along with this one. It’s an idea just about as dumb as it appears to be when you first hear it.

The idea that there is no free lunch comes from economists who use it to explain that actions that appear positive on first impression may bring about unintended and undesired consequences. Say that Congress were to adopt price controls in an effort to slow down inflation. That might cause a black market in the goods subject to the price limits, making it harder for people without access to the black market to obtain things they need. It is true that the appearance of a free lunch is often an illusion. Life is often a matter of weighing pros and cons; policy options that offer all upside and no downside are rare.

The problem is that the injunction against believing in a free lunch has been applied in contexts in which it does not apply. I argue in articles at this site that you can reduce the risks of owning stocks while also increasing the returns you obtain from stocks by adjusting your allocation in response to big swings in prices. My critics have argued that I am claiming to have discovered a free lunch and have rejected the idea as a logical impossibility. People are disputing what I say! Something must be done!

The reality is that free lunches are all over the place. Exercise is fun and yet it also improves your health and reduces your weight. It’s a free lunch. Falling in love increases your energy and stirs you to noble acts of selflessness. It’s a free lunch. Taking a hot bath on a cold winter day puts a smile of satisfaction on your face without requiring you to wait in any lines or find parking spaces. It’s a free lunch.

Life itself is a free lunch. You never paid for a ticket, did you? To reject any good thing you happen to discover on grounds that to believe in it would be to believe in a free lunch is morose madness. The entire trip is a free lunch, for heaven’s sake. Come on.

What happens in these sorts of cases is that someone comes up with a phrase that does a good job of summing up an important insight, it becomes popular as a result, and then over time people begin applying the insight in all sorts of inappropriate ways. There are indeed often hidden costs to decisions. Proposed actions are often not as positive as they at first appear to be. It makes sense to be wary of the idea that seems to promise a free lunch. It is madness, however, to reject the idea of a free lunch out of hand. Free lunches do exist and free lunches are wonderful. Finding free lunches is what the game of life is all about.

Rewards Given to Those Making Smart Investing Decisions Are Not Properly Thought Of as Being a Free Lunch.

Investors who change their stock allocations in response to dramatic price swings earn the roast beef sandwich they are paid as a reward. Those extra returns (at reduced risk) are not a free lunch. They are compensation for a job well done.

A Safer and Less Risky Way to Invest
Those changing their stock allocations in response to price changes are evidencing intelligence. It is proper and fitting that intelligent investing should pay off better than non-intelligent investing. It’s crazy that some today (this article was posted in December 2007) doubt this. It’s because those who doubt it are holding a weak hand that they feel compelled to bring in claims about lunches always coming with a price tag attached.

The no-free-lunch argument aims to unsettle those employing common sense when developing their investing strategies by suggesting that they are relying on wishes and dreams and desires rather than old-fashioned common sense. I suspect that those who deny that there are rewards for investing in a valuation-informed way turn to the no-free-lunch argument because it makes their own emotion-rooted strategies (the idea that prices might not affect returns has no support either in common sense or in the historical stock-return data) sound a bit more tough-minded than they would without benefit of this tough-sounding but inappropriately applied argument.

Those Arguing That There Is No Free Lunch for Smart Investors Are Counting on One of Their Own.

The idea that valuation-informed strategies are not rewarded is rooted in the Efficient Market Theory (Boo! Hiss!). This widely influential theory argues that there is no benefit to applying intelligence to investing choices because all of the thinking that could possibly do any good has already been done by others and factored into the prices of any stocks you might buy.

Um, right.

The Efficient Market Theory is the granddaddy of free-lunch claims. According to this theory, the wildest gambler who ever lived, the guy who falls for every story-stock claim that comes down the pike, can never make a bad call. If intelligence has no effect on investing results, the lack of intelligence cannot have any effect either. If you believe in the Efficient Market Theory, you believe that there is no possibility of anyone making a bad choice. The price is always right. Risk is always properly rewarded.

I believe that there is such a thing as a free lunch. But I don’t believe in ridiculous things. There are limits. Smart investors obtain better results than the other kind. There is no magic efficiency in the market that transforms our bad decisions into acceptable ones. There is a free lunch for those who earn it. And there is a fall into a pool of icy cold water for those who come to believe in the Efficient Market Theory and require a dramatic wake-up call.

The Force Will Not Be With You If You Do Not Accept the Free Lunch Given to Smart Investors.

New Economic Ideas

I view the Efficient Market Theory as a truly dumb idea. But that’s the least of it. What I really believe is that it is an evil idea. An evil idea. I’m not joking.

Look at the words from the Parable of the Talents quoted at the top of this article. I don’t get the sense that Jesus thinks we should be failing to make use of our investing insights on grounds that there is no thing as a free lunch. Do you?

It’s one thing to lack intelligence. If you lack intelligence, you should exercise prudence and caution in investing. I don’t consider myself the sharpest knife in the drawer re a lot of the questions that come up in InvestoWorld in the year 2007. So I exercise a good bit of caution and prudence myself. I consider it no sin to do so.

However, I would consider it a sin to turn off my brain to the extent that I would need to turn it off to persuade myself that my common sense and intelligence can in no circumstances be used to inform my investing decisions. What did God give me a brain for if not to make use of it? If I turn off my brain, I have sent God back his gift unopened. I have committed the sin of ingratitude.

You don’t need to be a Christian to relate to what I am saying here. My sons listen to Star Wars movies more often than is good for them. The background noise that I hear while writing the articles that appear at this site often refers to “the Force” and the importance of having it be with you. I think it would be fair to say that those failing to make use of common sense and intelligence in forming their investing strategies do not have the Force working with then. The Efficient Market Theory is an investing theory from The Dark Side. I think it would be fair to question whether it is a matter of pure coincidence that there is no photographic evidence showing Eugene Fama and Darth Vader having ever been present in in the same room at the same time.

Stocks Themselves Constitute a Free Lunch.

The free-lunch argument is employed to mock those who believe that it makes sense to apply common sense and intelligence to the investing project. Amazingly, the argument is usually put forward by people who purport to be pro-stock. Is it pro-stock to argue that stock investing must be mindless to be effective? It sure doesn’t seem so to me.

It is anti-stock argument. Consider this. If it really were so that common sense and intelligence could never provide an edge, would it not follow that those who use their common sense and intelligence to learn to invest in stocks rather than alternative investment classes are seeking an impossible free lunch? It follows.

Successful Investing

Stocks provide long-term returns superior to the returns provided by most other asset classes. Stocks constitute a free lunch. Those who deny the possibility of a free lunch deny the possibility that stocks could offer as good a long-run investing proposition as the historical data shows they really do offer.

The Efficient Market Theory is a theory rooted in fearfulness. People don’t see it that way because this is a theory that gained popularity during a wild bull market. The deep reality, though, is that to turn away from your own common sense and intelligence is to make a statement that you lack confidence in your ability to make your way in the world. Those who follow this philosophy of investing stand defeated in their own minds before they begin their efforts.

It Pays to Be Skeptical of An Apparent Free Lunch.

The no-free lunch idea would never have become so popular if there were zero truth to it. What is true is that things that seem too good to be true often are not true. It pays to be skeptical of an apparent free lunch. It’s when you come to believe that all exercises of common sense and intelligence are fruitless that you know that you have gone over the edge.

A Small Free Lunch Is a Big Deal.

Never let the significance of the compounding returns phenomenon stray too far from your consciousness. There are many ways to gain a small edge in investing. It is rare to identify something giving you a big edge.

A small edge is plenty. The compounding returns phenomenon transforms a small edge into a very large amount of dollars over the course of an investing lifetime. Please check out the Investor’s Scenario Surfer to see how investing in a valuation-informed way gives you an edge that will likely permit you to achieve financial freedom a good number of years sooner than would otherwise be possible.

Passive Investing Is Dangerous

Passive Investing Is Dangerous Because It Is So Easily Confused With Indexing.

I am a big believer in indexing. Indexing is buying shares of all stocks in a particular market so that your performance matches that of the overall market. Most investors are not able to spend the time needed to pick stocks effectively, so indexing makes a great deal of sense for a great number of people. I developed the Valuation-Informed Indexing approach to provide people a realistic means of taking advantage of the indexing strategy.

Passive Investing

I do not recommend passive investing. Passive investing is dangerous. I urge middle-class investors seeking financial freedom early in life to at all costs avoid passive investing. Passive investing can wipe out years of your savings. Don’t go there.

The biggest danger of passive investing is that it is so easily confused with indexing. Many investors view the two terms as synonymous. Indeed, many investing “experts” view the two terms as synonymous. I do not view the terms as synonymous. I view indexing as a good choice for intelligent investors. I view passive investing as a trap for the unwary.

Passive Investing Is Dangerous Because it is an Emotionally Immature Approach.

Indexing is an investing approach for those who have achieved a high level of emotional maturity. We all start out thinking that perhaps we will become the next Warren Buffett. Most of us are disabused of that notion after experiencing the financial losses often suffered by those guilty of such hubris. Indexers are investors who have overcome the need to brag at parties about their great stock-picking ability. They invest for less egocentric reasons — to provide for their loved ones, to overcome paycheck dependence, to finance their retirements. Indexing is emotionally smart.

Passive investing is not. Passive investors decide on a stock allocation, put it in an index fund, and then never adjust it in response to changes in stock prices. That’s not emotionally smart, that’s emotionally dumb. That’s a form of hubris greater than the hubris exhibited by those who believe that they can become the next Warren Buffett. Those thinking they can become the next Buffett can at least point to one guy who pulled it off — Buffett! I don’t know of anyone who has been able to ignore stock prices and not pay a price for doing so when the wild bull market that gave rise to the hubris became the wild bear market that inevitably follows.

The desire to index comes from a healthy place. Acknowledging that you are not likely to be able to outsmart the market is an act of humility. The desire to invest passively comes from a sick place. Thinking that stocks will perform during your lifetime in ways in which they never have before is an act of arrogance.

There is nothing to the indexing approach that requires that one engage in passive investing. Emotionally healthy indexing is active investing, whether achieved through picking stocks (which of course can be combined with indexing) or buying shares in indexes and adjusting one’s stock allocation in response to big price changes.

Passive Investing Is Dangerous Because it is an Irrational Approach.

Advocates of passive investing herald it as the most rational approach. I strongly disagree. Passive investors are not rational. They are rationalizing.

The idea that not responding to changes in prices is rational is an outgrowth of the Efficient Market Theory (I often refer to it as the Efficient Market Disease). I can see why those who believe in the idea that the market price is at all times in some mystical sense “right” believe that passive investing is best. If the market price is always equally appealing, why invest actively? There is a certain strange logic being followed by those who stick to the same stock allocation despite swings in stock prices from undervalued to fairly valued to overvalued.

The question is — Is the Efficient Market Theory rational? If the Efficient Market Theory is irrational and if investing passively is an idea that depends on the Efficient Market Theory for its logical support, then investing passively too is irrational. I have devoted years of mental effort to the task of trying to make sense out of the Efficient Market Disease (er, Theory) and have not been able to make even a tiny bit of sense out of it. If you prove more successful in this pursuit, you might want to give the idea of investing passively serious consideration. If not, I suggest that you dismiss it as an irrational approach.

investing passively

My view is that it is an emotional desire to Get Rich Quick that is the source of the appeal of passive investing. People know that when stock prices get out of hand the long-term value proposition of owning stocks drops, but they turn to theories like the Efficient Market Disease (it has gone by other names in other wild bull markets) for a time to block out consciousness of what they know.

Passive investors frequently cite “studies” and “theories” and “logic” in support of their investing choices. However, the drive behind exploration of these sorts of studies and theories and logic appears to be the emotional quest for the perpetual motion machine, for the fountain of youth, for the stock market that can go up and then not need to come back down. This is a non-reasoning sort of “logic.”

Passive Investing Is Dangerous Because it Makes Reasoning Impossible.

We all make mistakes. It’s part of life. When we discover them, we fix them. Passive investors can do the same, no?

No. Often they cannot bring themselves to do so. Persuading oneself that passive investing is a good idea is a difficult business. We all understand that prices matter when buying houses or cars or bananas. How is it that some of us are able to turn off our minds to the extent necessary to come to believe that prices might not matter when it comes to buying stocks?

It ain’t easy, that’s for sure. What passive investors do is to adopt a mindset which argues that possessing knowledge about investing is a bad thing. Passive investors don’t just conclude that market returns are good enough for those who don’t want to put in the effort required to pick stocks effectively; they argue that picking stocks effectively is impossible! They argue that Warren Buffett and the millions who have successfully followed strategies similar to those he follows are just lucky!

I’m not kidding.

I have seen numerous cases in which “experts” who advocate passive investing have made this claim. I have participated on discussion boards at which followers of such “experts” have said that their own strategies are rooted in a belief in such claims. I have heard such people refer to themselves as “Know-Nothing Investors.” They are proud of their unwillingness to apply their intelligence to the investing project. They see willful ignorance as a virtue when making investing decisions (but only then, I presume).

Not this boy. Find someone else. No can do. I can’t go for that.

Any investing approach that requires that you embrace ignorance of how investing works as a first step is terribly flawed, in my estimation. The big problem is that, once you declare yourself a Know-Nothing Investor, there is no hope of your ever learning from your mistakes. Passive investing worked well during the huge bull. It has not worked at all well since the wild bull came to an end in early 2000. But many passive investors maintain that the thing to do today (this article was posted in January 2008) is just to stick to the strategy.

What if stock prices fall still farther? The logic of the passive investing approach says that no change is justified even in these circumstances. Passive investors have no means of determining that they have made a mistake because their strategy is rooted in a rejection of the idea that intelligence can be applied to the investing project in an effective way. Not good.

Passive Investing Is Dangerous Because It Encourages Defensiveness.

Things often do not go the way we want in life. Often the best that we can tell ourselves in the face of things we do that hurt ourselves or others is: “Well, I tried my best.” Passive investors cannot do this. The best that they can say is: “I tried nothing.” It’s not the same.

The Great Safe Withdrawal Rate Debate has been a remarkable series of discussions. We have shown beyond any reasonable doubt whatsoever that the Old School safe withdrawal rate studies get a number that people use to plan their retirements wildly wrong (please see the “Risk Evaluator” section of the site for background). Yet the authors of the studies have not corrected them. “Experts” who have been asked to help get the word out to the retirees who constructed their plans pursuant to the demonstrably false claims of the Old School studies have been reluctant to help out. What’s all that about?

modern portfolio theory I can’t see into people’s minds and hearts. The best I can do is to offer my personal take on this. My take is that the authors of the studies and the experts we have contacted feel a good amount of guilt over the damage that they have done to retirees by their earlier support for the now discredited studies. It is not a small number of people who have suffered financial losses or taken on excessive risk as a result of these studies; the number is in the millions. And the analytical errors in the studies seem like painfully obvious ones once they are brought to people’s attention. “We forgot to account for the effect of valuation changes on long-term returns? Oops! Duh! Like, yeah, I guess we need to fix that! Duh-Duh!”

We need to fix that. But the first step to fixing it is acknowledging the harm done by our failure to note the error in the first place. For those who have come to think of themselves as “study authors” or “investing experts,” it’s not so easy a thing to do. Passive investing is willful blindness, for the reasons explained above. Willful blindness hurts humans and other smart, fun-loving mammals.

My sense is that many are attracted to passive investing because it at first appears to be such a no-muss, no-fuss approach to investing. They do so without making a sober assessment of the harm that this approach can cause down the line. After a good bit of harm has been done, it becomes difficult for these people to acknowledge that they were responsible for it; they seek refuge from taking responsibility for their mistakes in excuses and word games.

It is not an accident that passive investing has led to such irresponsibility. Adoption of a passive investing approach is a deliberate choice to ignore the most important and most basic lesson of stock-market history (that what goes up must someday come back down). The level of defensiveness that we have seen in the first six years of our discussions has been shocking and appalling; I certainly do not mean to excuse it. However, I don’t think that the fact that we have seen defensiveness should come as a total surprise; it is an inevitable consequence of widespread adoption of a fundamentally irresponsible strategy.

Passive Investing Is Dangerous Because It Makes Buy-and-Hold Strategies Unworkable.

Most passive investors say that they intend to practice buy-and-hold investing. That is, they plan is to avoid selling stocks when prices drop, the mistake that has caused middle-class investors of the past to view stocks as the riskiest of investment classes. A review of the historical stock-return data offers little grounds on which to place confidence in these claims.

The investors making these claims are right to argue the merits of a buy-and-hold strategy. Their mistake is in thinking that buy-and-hold is a realistic strategy for investors who are wildly overinvested in stocks. Investors who followed a passive approach as stock prices climbed to the la-la land levels where they reside today are by definition overinvested in stocks. The historical data shows that stocks become far, far more risky at high valuation levels. Investors who set their stock allocations at times of reasonable prices and then declined to make adjustments when prices rose to absurd levels have allowed reasonable allocations to become wildly dangerous ones.

Buy-and-hold investing makes a great deal of sense when employed by investors who make reasonable adjustments to their stock allocations at times of high prices. It does not make sense for those who fail to do so. Buy-and-hold and passive investing, like drinking and driving, do not mix.

Passive Investing Is Dangerous Because It Requires a Grim Determination to Suffer Bone-Crushing Losses.

Most passive investors possess little understanding of what sorts of losses they have set themselves up for by buying into the passive investing idea. There have been three times in the history of the U.S. market when stock prices have been in the same general neighborhood that they are in today. The average price loss for those three occasions was 67 percent. That number does not reflect the effect of dividends earned while prices were falling. When the dividends factor is incorporated into the analysis, the size of the expected real loss drops to only 40 percent.

investment theory Even a 40 percent loss in real portfolio value is a big deal to many of today’s middle-class investors. Many of today’s investors have been invested in stocks only at some point from the early 1980s forward. They have experienced a wild bull market personally. They know of what happens in the wild bear markets that inevitably follow wild bull markets only from reports in history books, which make a far less compelling impression.

I don’t believe that anyone should put a dollar into stocks without first learning about how much changes in price levels affect the long-term returns earned by investing in this asset class. The reality, of course, is that many do. The passive investing strategy exacerbates the negative consequences that follow from this unfortunate reality.

My guess is that many investors who are not believers in passive investing will get out of stocks when prices drop hard; they will suffer losses, but in many cases the losses will not be large enough to ruin them. Passive investors often vow to stick with their oversized stock allocations no matter what. That is truly a recipe for disaster. Those who sell at the bottom suffer the most from a bear (and those highly overinvested in stocks and vowing never to sell are obviously taking a big risk of being forced to sell near the bottom).

Stocks are not nearly as risky an asset class as they are made out to be. We make stocks dangerous with our unwillingness to acknowledge the lessons of history. Investors who elect to ignore the effect of valuations on long-term returns make stocks a far more risky investing class than they were meant to be.

Passive Investing Is Dangerous Because It Discredits Indexing.

Indexing will be blamed when passive investing causes middle-class investors to suffer huge losses. But it won’t have been indexing’s fault. There is nothing in the nature of indexing that requires those employing it to ignore valuations.

I believe that the public’s faith in indexing will be restored in time. But I also believe that it is unfortunate that indexing has become associated in the public mind with passive investing. I would like to see responsible advocates of indexing do more to point out that there is no necessary connection between the two ideas.

Passive Investing Is Dangerous Because It Encourages Consideration of Other Dubious Investing Beliefs.

All investing involves risk. It is the nature of the beast. Investing passively increases the risk dramatically and in a way that serves no possible constructive purpose (the drive behind passive investing seems to be rooted in the most negative of investing emotions — a raging greed or an unconquerable fear). “Solve” the struggle with risk that way (passive investors address risk by ignoring it and thereby making it many times more potent a problem), and you encourage the adoption of all sorts of dubious ideas about what works in investing.

Eugene Fama

Review the comments of indexers posted in the “Investing Discussion Boards Ban Honest Posting on Valuations!” article (please see the “Banned at Motley Fool!” section of the site) and you will see numerous observations of the rabid dogmatism of those following the Lindauerhead approach to indexing. Is there something about indexing that requires dogmatism? Obviously not. If all indexers were as extreme as the Lindauerheads, we wouldn’t have seen so many participants at The Old Vanguard Diehards Board objecting to it.

My sense is that it is a rigid adherence to the tenets of passive indexing that brings on unhealthy levels of dogmatism. Most indexers are reasonable. Those who try to defend the passive investing idea in reasoned discourse find it so difficult to make a rational case that they turn to dogmatism and defensiveness to block out questioning. It is but a small step to claims that indexing is for everyone, even those quite able to pick stocks effectively.

Dogmatism begets dogmatism. Defensiveness begets defensiveness. I refer to the Efficient Market Theory as a disease because I have seen on a number of discussion boards how it can turn otherwise smart and good people into frothing-at-the-mouth attack dogs. There’s something deeply wrong with an investing strategy that has a long history of turning humans into monsters. There’s something not right about that theory and about the investing approach that is its bad-seed child.

Passive Investing Is Dangerous Because It Plays Games With Your Mind.

A number of Lindauerheads have described their investing history prior to their discovery of passive investing as a testing of various Get-Rich-Quick approaches that ultimately did not pay off. I believe that passive investing is for these people just one more in a long list of brilliant mistakes.

The most convincing salesman is the fellow who persuades you that he is not trying to sell you something. That’s passive investing. The pitch made for it causes us to let down our guard because it all sounds so — well, passive. It hardly even sounds like those making a pitch for passive investing are trying to sell us something.

But they are. They are trying to sell us on the idea that it all is going to turn out different this time. Check out The Investor’s Scenario Surfer (see tab at left). It is rare to turn up a scenario in which passive investing (rebalancing is a passive strategy) provides better results than valuation-informed investing. So why have so many bought into the promise that passive investing might work out this time?

Index Mutual Funds It sure sounds good at the top of a bull. On the one hand, those following passive strategies are told that they are smarter than all their friends. On the other, they are told that they don’t need to know anything or to learn anything to become so gosh-darn smart. A great wave of intelligence passes over those smart enough to listen to the pitch and not raise any difficult questions.

Passive investing sounds too good to be true.

I wonder why.

Woody Allan’s Take on the Efficient Market Theory

“If I listen long enough to you,
I’ll find a way to believe that it’s all true.

–Tim Hardin, ”Reason to Believe”

Woody Allen tells a joke with relevance to today’s stock investor (this article was posted in March 2007) in the movie Annie Hall. It seems that there is a fellow who complains to a psychiatrist that his brother thinks he’s a chicken. The shrink asks the fellow why he doesn’t turn him in. The fellow explains that: “I would, but, you see, doctor — I need the eggs.”

Woody says that relationships are like that. They’re often a crazy and mixed-up business. But we keep at them because “most of us, we need the eggs.”

Woody Allan's Take on the Efficient Market Theory
I say investing is like that. The Efficient Market Theory is today’s dominant model for how investing works. It says that investing is a rational endeavor and that thus the market price always comes close to being the right price. No investor should try to outguess the market by lowering or increasing his stock allocation in response to price moves, according to this theory, because there is just no way to form a better idea of the right price for stocks than that old efficient market.

This is a dangerous sort of silliness, of course. The first great truth about stock investing is that the market price is always wildly wrong in one direction or the other or at least on its way to becoming wildly wrong. Investors get wildly over-enthusiastic over stocks, push prices up to absurd levels, suffer big losses, and then get wildly under-enthusiastic over stocks just when prices become highly appealing. We need to junk the Efficient Market Theory and replace it with something that better explains the investing realities as they exist here on good old Planet Earth. Are you ready for the rise of the Emotional Market Theory?

Not all of us are entirely prepared to take that step in the direction of rationality (yes, it’s more rational to acknowledge that we have emotions than to practice denial on this point) just yet. Not to worry. You don’t have to stop believing in the Efficient Market Theory just because you know it’s not true. This article offers a handy-dandy list of twenty-four of the more popular rationalizations used by those seeking a reason to believe for just a wee bit longer.

Rationalization #1 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Lots of Experts Haven’t Entirely Given Up on It Yet.

Perhaps they don’t express their belief with as much conviction as they did back in the Summer of 1999. But few experts have come out and said flatly that they do not believe in the Efficient Market theory. That’s something.

Rationalization #2 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — The Experts Who Have Given Up on It Don’t Make Much of a Fuss About It.

Some experts have given up, of course. There recently was a discussion at the Vanguard Diehards board at which William Bernstein said that he believes only in the micro version and not the macro version of the Efficient Market Theory. The macro version is the one that counts for the purist indexers who congregate there because it is their belief in a macro-efficient market that causes them to believe that they should not change their stock allocations in response to wild price swings. So that was potentially a bombshell admission. Not to worry, though. The entire board community just pretended that Bernstein never said it, and life went on as usual. I don’t get the feeling that Bernstein is preparing an article exploring the implications of his belief that the market is not macro-efficient. So long as we all pretend that he never said what he said, it doesn’t really make much difference that he said it, does it?

Rationalization #3 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Most of Your Friends and Neighbors and Co-Workers Believe In It.

Can 600,000 Elvis fans all be wrong? No way. Neither can the millions who continue to believe in the Efficient Market Theory despite it all. Don’t worry, be happy.

Rationalization #4 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Theories Don’t Matter Anyway.

Say that there’s not a grain of truth to the Efficient Market Theory. It’s just a theory anyway, right? Stock prices haven’t come down yet. So everything’s cool.

Rationalization #5 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Believers Are Ahead of Their Time.

Investing theories discredited

A belief that the market price is the best price is a belief that comes into and out of fashion, depending on how high stock prices have gone. We’ve seen this theory become popular before and we will see it become popular again. It may be that as prices come down there will be fewer and fewer investors willing to say a kind word on behalf of the theory. But prices will go up again someday, and the theory will be king once again. There is no reason why those refusing to give up their belief in the theory need to think of themselves as a little behind the times. They just as properly can think of themselves as a good bit ahead of the times.

Rationalization #6 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It Makes It Easier to Understand How Stock Investing Works.

Most of today’s investing literature is rooted in an assumption that the Efficient Market Theory is true. Most of the existing articles are a pain to work your way through now. Can you imagine how much worse it is going to be if you acknowledge that the Efficient Market Theory is bonkersville and so even the parts that now seem to make some sense no longer do? Do we really need to open this can of worms?

Rationalization #7 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Updating Investment Strategies Is a Lot of Work.

It’s not just the articles in the investing literature that become out of date once you throw the Efficient Market Theory into the trashbin of history. That move renders the investing strategies rooted in a belief in the theory out of date too. Hello? Do you enjoy reformulating your investing plan? If not, perhaps you had better let sleeping dogs lie and pretend you never heard any of those arguments for why the Efficient Market Theory does not add up.

Rationalization #8 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Acknowledging the Realities Could Give Rise to Transaction Costs.

If you change your stock allocation to something more realistic, you will incur transaction costs. Ignore the flaws in the Efficient Market Theory, and you avoid these costs. It’s found money! The proverbial free lunch!

Rationalization #9 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — You Might Mess Up Anyway.

Say that you abandon the good old Efficient Market Theory and replace it with some more realistic investing model. Does it follow that you will obtain good results with your investing choices from that day forward? It does not. Anyone can mess up, even those smartypants types who abandon the Efficient Market Theory on the 101st sign that it doesn’t work. Sheesh! At least those messing up because they stuck with the Efficient Market Theory will be able to say that they didn’t expend any additional effort in the cause of messing up, that the mess-up just sort of crept up on them naturally.

Rationalization #10 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Believing Hasn’t Hurt Us Much So Far.

Investing Confused

U.S. Stocks have not performed as they are “supposed” to for seven years now. But they haven’t done so terrible as of yet either. Is there some reason why we need to abandon the Efficient Market Theory now, before we even experience a price crash? Where’s the fire?

Rationalization #11 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stocks Might Perform Differently in the Future Than They Have in the Past.

The biggest argument against the Efficient Market Theory is that stocks have never in the past performed in the way in which this theory says they are supposed to perform. I can understand why some folks see that as a problem. Still, there’s no guarantee that stocks will perform in the future as they have in the past. Isn’t it possible that stocks could today begin performing as the Efficient Market Theory says they are supposed to perform? Stranger things have happened.

Rationalization #12 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stock Prices Could Go Up Sharply in the Short Term.

Even those who point out the flaws of the Efficient Market Theory acknowledge that stocks can go up in the short term, no matter how high prices are today. Do you really want to miss out on all the exciting action? Did I not hear you observe one day not too long ago that “baby needs a new pair of shoes!” Think it over.

Rationalization #13 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It Would Require Admitting That You Were Wrong at An Earlier Time.

Admitting that you were wrong about something is a bummer. Tell me I’m wrong about that one! I mean, don’t tell me!

Rationalization #14 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Short-Term Timing Doesn’t Work.

If the Efficient Market Theory is not true, there is no reason not to engage in long-term timing. It would be crazy not to change stock allocations a bit in response to wild price swings if it is possible to know when prices are truly out of whack. Still, it’s easy to engage in word games that will serve to confuse yourself and others on this point. There is lots of evidence that short-term timing doesn’t work. Both the phrases “short-term timing” and “long-term timing” have the word “timing” in them. Do you appreciate the opportunities presented by this reality to keep yourself and others in a fog as to how investing really works for a long time to come?

Rationalization #15 for Continuing to Believe in the Efficient Market Theory Even After Learning That It’s Not True — You Can Always Change Your Mind Later.

After stock prices crash, there won’t be much point in sticking with the Efficient Market Theory. Fine. You can abandon your belief in the Efficient Market Theory then, along with lots of other folks. Must you be an early adopter? Haste makes waste.

Rationalization #16 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Even Retirees Might Survive the Effects of Believing in a Flawed Investing Theory.

One of the arguments against the Efficient Market Theory is that belief in it is going to cause a lot of busted retirements among retirees who put together their retirement plans without considering the effects of high valuations on the long-term survival of those plans. It of course makes the theory sound bad to point out the human suffering that is likely going to follow from a widespread belief in it, assuming that stocks perform in the future somewhat as they always have in the past. But the reality is that retirees have options. Couldn’t they tighten their belts and live on less? Must we all give up the comfort of our belief in the Efficient Market Theory out of concern for the effect that continued belief in it will have on a few million retirees? Is that not a bit of an overreaction?

Investing 101 Rationalization #17 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — New Theories Might Contain Flaws Too.

It’s taken us some time to learn about the flaws in the Efficient Market Theory. We don’t know about the flaws of the investing model that will replace it yet because we haven’t seen it in action yet. It’s really not fair to compare a theory that has been tested and that has failed with a theory that has not yet been tested. At least we know about the flaws of the existing theory. Who knows what sorts of flaws we will discover in years to come in whatever theory comes to replace it? Replacing the Efficient Market Theory is like replacing an old pair of sneakers just because they have holes in them. Who wants to give up those comfortable old sneakers?

Rationalization #18 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — There is Almost Certainly Some Truth to the Efficient Market Theory.

The Efficient Market Theory is not entirely wrong. There are indeed pockets of efficiency in the stock market. Must we be so persnickety as to demand that our investing models be accurate as stated?

Rationalization #19 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Giving Up on the Efficient Market Theory Might Complicate Investing.

One nice thing about the Efficient Market Theory is that those relying on it to understand investing don’t need to worry about all that icky emotional stuff. Include that stuff for the sake of accuracy and you are going to end up with a more complex investing model. Not good.

Rationalization #20 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It’s More Important to be Rich than to Be Right.

Lots of people made a lot of money by believing in the Efficient Market Theory during the wild bull market. Those people are a lot richer today than the sorts of people urging us to move into sissy investments now that prices are so high. Need I say more?

Rationalization #21 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — It’s Better to be Lucky than to be Smart.

Problems with conventional investing advice

There are some scenarios that people have imagined in which continuing to believe in the discredited theory might not hurt us so much. You never know.

Rationalization #22 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Those Who Have Been Investing Long Enough Will Likely End Up Ahead Anyway.

Those who have been buying stocks since the early 1980s are so far ahead at this time that they will likely remain ahead regardless of what happens as we return to reasonable prices. Why is it again that some say we need to replace the Efficient Market Theory?

Rationalization #23 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — If You Change Your Stock Allocation, You’re Just Going to Have to Change it Back Again Later.

Say that you abandon ship on the Efficient Market Theory and adjust your stock allocation to something more realistic for today’s price levels. You’re just going to have to adjust it back up again when prices fall. Who needs the botheration?

Rationalization #24 for Continuing to Believe in the Efficient Market Theory After Learning That It’s Not True — Stop Believing, and You’ll Have to Acknowledge Your True Net Worth.

Efficient Market Theory Cons

The next step after acknowledging that today’s market prices are la-la land stuff is acknowledging that the value you now assign to your stock portfolio is la-la land stuff too. Let’s see, stocks are now priced at about double their fair-value price. That means that your stock portfolio is worth about…

…You don’t want to go there. Trust me on this one.

Explanatory Note: This article aims to make a serious point by employing a good number of goofy arguments. The idea here is not to have you see merit in any of the goofy arguments. The point is to see if we can get papers drawn up to turn that crazy brother of ours into the authorities. We don’t need the eggs that badly!

Do we?


Who’s Afraid of the Efficient Market Hypothesis?

All the ladies in Washington are scrambling to get out of town.

–Dylan, “Thunder on the Mountain”

Critics of the Efficient Market Hypothesis Need to State Their Case in Stronger Terms.

Efficient Market Hypothesis

Robert Shiller does not believe in the Efficient Market Hypothesis. He has been engaged in research that refutes it for decades now. His book Irrational Exuberance makes the most painstaking and detailed case for a non-efficient market that has ever been written. Given all that, the words that Shiller uses to describe his views on the Efficient Market Hypothesis are remarkably restrained.

Here’s Shiller:

“The efficient markets theory and the random walk hypothesis have been subjected to many tests using data on stock markets, in studies published in scholarly journals of finance and economics. Although the theory has been statistically rejected many times in these publications, by some interpretations it may nevertheless be described as approximately true. The literature on the evidence for this theory is well-developed and includes work of the highest quality. Therefore, whether or not we ultimately agree with it, we must at least take the efficient market theory seriously.”

Et tu, Robert? Approximately true? Is being “approximately true” anything like being “almost pregnant”?

The Efficient Market Hypothesis is either true or it is false. Those are the only options. There is no “approximately true.”

Say that you were building a bridge. My understanding is that the people who design bridges rely on some form of calculus or some such thing (insert bad memory flashes here!) to know what sorts of materials are needed and where stuff needs to fit together and all that sort of jizz-jazz. Say that the people designing bridges were all relying on an understanding of mathematics that was only “approximately true.” That would be bad, right? Real bad, right?

I do not like the idea of driving over bridges designed pursuant to calculations that are only “approximately true.” Nor do I like the idea of investing my money (or seeing other people invest their money) pursuant to an investing theory that is only “approximately true.”

Is it true or is it not? Does the theory stand up to scrutiny or does it not? It matters. Can we get some of the big minds in the investing field to devote some mental energy to this question and come up with an answer that either warns us away from further reliance on the efficient market hypothesis or that offers us reassurance that all really is well and that we are not likely going to lose big portions of our life savings in days to come? It is my strongly held view that middle-class investors have every right in the world to expect that answers of this nature will be forthcoming from those who present themselves as experts in this field.

Many “Experts” Appear Not To Be Clear in Their Own Minds As to Whether They Believe in the Efficient Market Hypothesis.

One of the most surreal moments that I have ever experienced on a discussion board (and I have several dozen exceedingly surreal ones in my file) was the moment in which William Bernstein (author of The Four Pillars of Investing) declared on the Vanguard Diehards board that he does not believe in the macro version of the efficient market hypothesis (the macro version says that the overall market price is always in some sense “right”). I see nothing odd in the comment itself; the comment is pure common sense. The surreal part was that the leaders of the board, who respect Bernstein greatly and who run vicious smear campaigns against posters who express doubts about the efficient market hypothesis, ignored the comment. I suppose that they were too embarrassed to run a vicious smear campaign against their hero. But why didn’t they acknowledge having long been wrong in waging the smear campaigns used against many others? Why didn’t they change their views in response to this important new information bit?

It’s not done. I have never known anyone who at one time was an advocate of the efficient market hypothesis say that he or she has seen the light and now acknowledges the error of his or her former ways. Why not? Shiller’s book is an extended argument against the hypothesis. The book was a widely praised bestseller. Did it not change anyone’s mind? If it did, did that person go public with acknowledgment of the change of heart? Can you tell me who that person is?
Shiller Investing
Books are supposed to change minds. That’s the point. Did Shiller fail? Has his book been found universally unpersuasive? If it is so terribly unpersuasive, why did so many people praise it and why did so many people buy it?

I don’t think that’s it. I think that many found the arguments put forward by Shiller to be compelling. My sense (that’s all it is) is that many have to a considerable extent lost confidence in the dominant investing model of today and yet are reluctant to publicly say so. I believe that many of today’s investing experts are afraid to acknowledge that they no longer believe in the efficient market hypothesis.

They know too much and they care too little.

The Efficient Market Hypothesis Changed the History of Investing.

I conclude that they care too little when I bring to mind thoughts of what all this suggests is likely to happen to middle-class investors in days to come.

The efficient market hypothesis changed the history of investing. For many years, middle-class investors evidenced a healthy appreciation of the risks of stock investing, especially at times of high prices. The new theory says that prices do not matter, that there is no need to be concerned that valuations have recently gone to the highest levels ever recorded in the history of the U.S. market. If the theory is wrong, millions of us are doing 90 on a slick road surface without knowing it.

We have come to believe that we are investing prudently, but from the standpoint of the investing wisdom that prevailed prior to the rise in popularity of the extraordinary “Don’t Worry, Be Happy” investing mindset of the early 1980s forward, we are not. The efficient market hypothesis had better stand up to scrutiny. If it does not, a whole big bunch of us are well-positioned to experience a financial wipeout in the not too distant future.

How big a wipeout are we talking about? Here’s Shiller again: “If over some interval in the first decade or so of the twenty-first century the U.S. stock market is going to follow an uneven course down, as well it might — back, let us say, to its levels in the mid-1990s or even lower — then individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate by the trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”

Oh, good. At least there’s nothing to be alarmed about then.

Shiller doesn’t believe in it. Bernstein doesn’t believe in it. Robert Arnott doesn’t believe in it. Andrew Smithers doesn’t believe in it. Cliff Asness doesn’t believe in it. John Walter Russell doesn’t believe in it. David Dreman doesn’t believe in it. John Bogle has expressed serious doubts.

The theory has been around since the late 1960s. There has been plenty of time to check it out. If it passed the test, why is it that there are so many big names who are not convinced? If it failed the test, why is it that there are so many big names failing to warn us about the slow train coming up around the bend?

I’m thinking that maybe we should get a memo drafted and send copies to the millions of middle-class investors whose hopes for secure retirements are at stake. Is there anyone able to point to any possible downside?

Most Middle-Class Investors Do Not Know What the Efficient Market Hypothesis Is.

It’s not as if middle-class investors can figure this thing out for themselves.

Behavioral Finance Investing

The typical middle-class investor invests at least partly pursuant to the dictates of the efficient market hypothesis. The typical middle-class investor doesn’t know what the efficient market hypothesis is. What he knows is that most of the experts say that long-term timing doesn’t work and that prices don’t matter and that stocks are always best for the long run and that those who take on the risks of stock investing are sure to be compensated for doing so. These claims have been repeated so many times by so many people for so many years that the typical middle-class investor assumes there must be something to them.

If the efficient market theory fails, all of the ideas that follow from a belief in it fall too. Oh my!

The “experts” need to figure out what they believe. Then they need to report on what they come up with to the middle-class investors who have placed their trust in them. Yes, I really think that that’s the right and proper thing for them to do at this point in the proceedings.

The Appeal of the Efficient Market Hypothesis Is the Safety It Provides (Not for Investors, But for “Experts”).

I’ll share with you my take re what is going on. I don’t think that a lot of the “experts” spend a lot of time thinking through the theories that support the investing advice they offer. My sense is that what many are trying to do is to offer advice that is not wildly wrong, that is perceived as being reasonable, that will not get them in too much trouble. Advice developed pursuant to the efficient market theory fits the bill.

This stuff comes approved by tenured university professors. What could be more respectable? What could be more legitimate? What could be more safe? There’s a point at which a thing can become so safe that it’s dangerous. Anything perceived as so safe that it may never be questioned is dangerous.

The reality is that investing is a messy business. There really are pockets of efficiency in the market. There is a place for the numbers-based analyses that are done pursuant to the theory. The hypothesis properly reflects about half of what is involved in understanding how stocks really work. The half it ignores is the emotional side of the story. It is emotions that cause wildly overvalued markets like the one we are suffering through today (this article was posted in December 2007). The emotions stuff is harder to reduce to numbers than the non-emotional “efficient” stuff that is the sole concern of those who believe in the hypothesis.

Describe the investing project realistically and you need to make reference to fear and greed and envy and panic and anger and hate and all sorts of yucky junk. The sorts of people who aspire to become investing gurus generally would prefer to keep it to just the numbers, ma’am. They don’t like the uncertainty that comes into play when describing the effect that human emotions have on investing returns. Those who become believers in the efficient market hypothesis don’t have to! Today’s dominant model for explaining how investing works does away with all that with the wave of a magic wand. As Church Lady so often observes: “How convenient!”

Do they believe what they say? Kinda, sorta. My sense is that most don’t think about these sorts of questions hard enough to make it possible to say for sure whether they believe it or not. They say some things that suggest a strong belief in the theory and they say other things that suggest grave doubts. A good number do not seem to feel that it is imperative that they resolve the conflicts in their views. When I find myself in times of trouble, Mother Mary comes to me speaking words of wisdom: Let it be, let it be, let it be.

I’m with Paul Simon, who retorted: “I know they say ‘let it be,’ but it just don’t work out that way.” Let it be and we are likely to see millions of middle-class lives ruined. Could it be that Mother Mary really wants those of us who understand the flaws of this theory to let it be regardless of the consequences likely to follow? Yes, Mother Mary is forgiving. And Mother Mary is tolerant. And Mother Mary is gentle. All that is so. The other side of the story is that Mother Mary is honest. And Mother Mary is prudent. And she is kind. And she is smart.

Shiller on InvestingIt’s easier for the “experts” not to do the intellectual battle required to come to a firm conclusion one way or the other. The ones who suffer most from their failure to do so are the middle-class investors left holding the bill for the fire damage. That’s why God made middle-class workers, isn’t it? They’re the one who pay the bills when the goofy grandiose schemes concocted by their betters go wrong. Have you ever noticed that that is often the way it works out?

I’d like to hear some clearer statements. You’ve probably noticed that I have made it a practice in recent months to frequently put the word “experts” in quotes. I question whether people who cannot say in clear and direct and simple and unambiguous language what they believe about the dominant investing model of the day are truly “experts.” They haven’t earned the title. I don’t think I have earned the title either, for other reasons. I do feel obliged to at least try to answer the most important questions, however. I make an effort to address myself to the basics without fear or favor.

You don’t want to wait until prices have fallen hard to begin demanding clear answers to hard questions. If you feel any worries about the sorts of things I am making reference to in this article, now is the time to be making your voice heard.

It’s Going to Take Strong Language to Bring Down the Efficient Market Hypothesis.

I don’t think there is much to the theory. I think the efficient market hypothesis is going to fall of its own weight once the secular bear market that we appear to have entered in the year 2000 quits putting forward dark forebodings and gets serious about its job of stripping us of our bull market illusions. The efficient market hypothesis has never been tested in a secular bear market. Just about everybody who believes in it believes because of things they saw happen in a wild bull market and will stop believing when their reason for believing goes “poof!”

We won’t all stop believing at the same time. Those who stop believing first stop believing best. Those who continue believing longest pay the highest price for doing so. We’ve all had the injunction “Buy-and-Hold” drilled into our brains since the early days of the wild bull. It may be that we are going to need to learn a new catch phrase. Think-and-Protect?

It is the role of the investing expert to warn us about this sort of thing. That’s the job.

It doesn’t work for the experts to only begin to express doubts after prices have fallen a good bit. Humans don’t change their fundamental beliefs in a day or a week or a month. If the experts have doubts, they need to be giving voice to them today.

They need to be expressing their doubts in strong language. Shiller says that: “We must at least take the efficient market theory seriously.” I don’t agree. My inclination is to ridicule it.

Not to be mean. Not to be rude. Not to be difficult. There’s a place for ridicule. Ridicule is properly directed at ridiculous things. I see the efficient market hypothesis as a ridiculous thing.

And a dangerous thing. The Myers-Briggs personality assessment tool characterizes me (I’m an INFJ) as a “Protector.” Protectors protect. When we see our friends in trouble, we speak up, even if we are by nature a bit on the shy side. We force ourselves to step forward and have our say because we care about what happens to our friends. When we see our friends being hurt because people they depend on for the straight story lack the courage to provide it, we get steamed. The steam shows in the language we use. We ridicule ridiculous things.

There are lines that need to be drawn. I certainly do not favor personal nastiness of any sort. It’s one thing to ridicule an investing theory that has become far too big for its britches. It’s something else to start throwing stones at humans doing the best they can to make sense of this stuff under difficult circumstances. You’ve heard me taking shots at the Ivory Tower Eggheads. When it’s a particular Ivory Tower Egghead under discussion, I make it a point to observe that the fellow (it’s always a guy, isn’t it?) is a plenty smart individual. I believe that that’s the right thing to do. It’s not easy getting a gig as an Ivory Tower Egghead nowadays. Ivory Tower Eggheads work hard for the money. Still, my heart is with the middle-class investors. My general rule is to ridicule the idea, but not the people who advocate it.

People won’t stop believing in the idea until the idea is widely ridiculed. That’s what it takes to break through all the noise of the marketing campaigns in support of the efficient market hypothesis. There is no “there” there for the efficient market hypothesis. It’s silly. That’s my true take. Should I not put forward my true take?

What Happened to Stocks?

Not many do. Many of those who hold more realistic views on investing than those held by adherents of the efficient market hypothesis are careful not to step on toes, not to cross lines, not to offend, not to play their records too loud. This worries me. The one thing that I consider “serious” about the efficient market hypothesis is that it stands a serious chance of doing some serious harm to a serious number of good people. It’s seriously scary and those of us who see through it should be using some serious words to make some serious fun of it.

I sympathize with the desire not to offend; when I want to hear the Clash at full power, I put on headphones. But being quiet and thereby causing people to lose money is more offensive than letting people know that an investing idea that they have bought into is not all that it is cracked up to be. Those of us who see the holes in this theory find ourselves in circumstances in which we are required to offend one way or the other. I would far prefer to see my friends struggle with the pain of hearing some strong words about the weaknesses of their investing ideas than to struggle with the loss of a large portion of their life savings. If it takes being a bit “offensive” to get the word out about this silly and dangerous theory, I see it as an act of charity to put forward a few “offensive” words from time to time until the worst of the trouble has passed.

To Appreciate the Horror of the Efficient Market Hypothesis, You Need to Visit Investing Discussion Boards.

I didn’t become an investing “expert” by reading books or by taking courses or by managing big funds. Whatever expertise I can be said to possess I possess by virtue of the work I did during The Great Safe Withdrawal Rate Debate. I played the lead role in the most significant series of investing discussions in the history of Planet Internet and I learned some frightening stuff while doing so.

A good number of today’s stock investors are in pain. They are aware of the weaknesses of their investing beliefs. They do not want to face the problem. They want to avoid the problem. They hate the idea of being forced to deal with the problem. They are inclined to strike out in anger at anyone who confronts them with the realities.

That’s not good. Things are in a very, very, very, very bad way. It’s the fault of the efficient market hypothesis. This “theory” is an anti-thinking theory. If the market price really were always right, there would be no point in learning anything about how to invest effectively. By denying the effect of emotions on investing results, the hypothesis made investing a far less rational and thereby a far more emotional endeavor than it has ever been before. Until we put this theory to its final rest, stock investing will remain a dangerous, dangerous business for the middle-class investor.

I’ve seen reasonable people try halfway measures. I’ve seen posters who understand the weaknesses of the theory but who very much do not want to offend seek to criticize it gingerly, in a way that doesn’t stir up the anger of the theory’s defensive defenders. It never works. It never works. It never works. It never works. Those with the biggest emotional investment in the theory are too frightened to go along with halfway measures. They need to be told they are wrong. They need to come to terms with that reality before they can get themselves moving in the right direction again.

Efficient Market Debunked That’s it. That’s the magic. They need to be told they are wrong. Once they accept that they are wrong, the healing process begins. It can never begin so long as the rationalizations continue. Rationalization is the sickness and it is going to take some strong medicine to set things right after so many years of us hearing experts encourage the illusions that come natural to us as the consequence of our fallen nature.

The experts need to come down from their ivory towers, visit a few boards, and learn how real live people have come to make use of the efficient market hypothesis. The people are in a jam. The theory put them there.

If it’s only approximately right, it’s perfectly wrong. We need to take this one down.


When you believe in things you don’t understand,
You suffer.

–Stevie Wonder, “Superstition”

The Efficient Market Concept is A Big Bunch of Hooey

Those Who Believe in an Efficient Market Are Not Able to Say With Much Clarity What It Is.

The Efficient Market Theory posits that all that there is to be known about stocks is already incorporated into the price of stocks. Thus, there is said to be no benefit gained by learning things about stocks. Anything that you could come to know others have come to know before you and those others have caused this information to be reflected in the price available to you. Researching stocks is pointless, according to the theory. It is also pointless to adjust your stock allocation in response to price changes.

Efficient Market Concept There are grown men and women who claim to believe in this Easter Bunny of a theory (please see my note re the Easter Bunny comment posted at the bottom of this article). The thing is, it’s got a good bit of marketing muscle behind it. It’s been referenced on Jeopardy. It was recently named the official stock investing theory of the 2008 Olympics. I’m not even allowed to write about the efficient market on those days when I write my blog in my pajamas. The Blogger’s Code of Ethics require that I put on a shirt with a button-down collar and a tie before venturing an opinion on the market and its perceived efficiency or lack thereof.

I have found it to be a frustrating experience arguing against the Efficient Market Theory on discussion boards. It’s not hard to formulate the arguments. What’s hard is getting advocates of the theory to stick with a single definition long enough for me to be able to explain why a theory so defined does not hold water. Many people understand the implications of the theory — effective stock-picking is not possible, timing doesn’t work, stocks are always the best long-term bet, risk is always rewarded. Few (if any) can say with much precision what it is.

The things that people believe about stocks influence the price of stocks. We all get that. Saying that alone is like saying that water is wet; it doesn’t tell us anything beyond something that is so obvious that it isn’t worth anyone taking the trouble to tell us the news. The Efficient Market Theory must say something more than that or it wouldn’t have been named the official investing theory of the Olympics. It’s when the time comes to identify that all-important something else that the talk of efficient market advocates gets slippery.

Is the market price the right price? They say “no, not necessarily.” Is the efficient market concept rooted in a belief that investors are 100 percent rational? They say “no, not necessarily.” Does efficiency rule out price bubbles? They say “no, not necessarily.”

I’m writing an article about the efficient market and, truth be told, I don’t know what it is. I’ve read definitions of it in books and on web sites. The definitions I’ve read do not provide my brain with the nutritional information bits it needs to be able to make sense of this “theory.” I put the word “theory” in quotes because I personally do not believe this thing qualifies. My sense is that it is more properly referred to as an “assumption.” I sometimes think that even that suggests more solidity than is warranted; it might be that someday the efficient market will be looked back on as nothing more than a notion that was shared by a number of people for a certain stretch of time. On days when I am feeling footloose and fancy free, I have been known to refer to it as the Efficient Market Disease. I’m not a fan.

The Efficient Market is so ill-defined that trying to prove its nonexistence is akin to trying to prove the nonexistence of a ghost. The advocates of the theory give it no shape or outline or matter. So those of us seeking to prove its nonexistence are left saying: “Do you see all of that nothingness in front of you? That’s not a ghost as you insist it is, it really is just the nothingness that it appears to be!”

There’s No Efficient Market Unless Investing Is a Rational Endeavor.

Saying that the efficient market concept is so vague that there is no need to present an argument against it makes for an extremely short article. To insure that you get your money’s worth on today’s visit to my site, I am going to employ an assumption of my own for the purpose of giving the idea of an efficient market enough substance to provide me with something to talk about. I am going to assume that what the efficient market enthusiasts are trying to express is a belief that investing is a 100 percent rational endeavor.

Boring Investing Advice If investing is even slightly an emotional endeavor (it is primarily an emotional endeavor, in my assessment), I am not able to imagine any mechanism by which all information about stocks could come to be properly incorporated into the stock price. The only way by which I am able to make any sense at all out of the efficient market concept is to assume that its advocates believe that investing is entirely a rational endeavor.

The remainder of this article proceeds from that assumption. I argue that, even if investing were primarily a rational endeavor (I do not believe that it is), the Efficient Market Theory would come up short.

The reality (in my view, of course) is that, if investors were rational, they could easily see the irrationality of the Efficient Market Theory. It is only because investing is primarily an emotional endeavor that there are a good number even willing to entertain the idea that the market might be efficient.

There’s No Efficient Market If Important Information About Stocks Is Not Made Public.

The Stock-Return Predictor (see tab at left) tells you the most likely 10-year annualized return for stocks starting from today’s valuation level (this article was posted in November 2007), presuming that stocks perform in the future at least somewhat as they always have in the past. John Walter Russell and I began the research that led to publication of the calculator in May 2002 and published it in July 2006. Say that we both lost interest in the project in June 2006 and never published the calculator. The information transmitted to investors through the calculator would have existed in our heads but not in the heads of other investors. Would that not have given us an edge?

It would have given us an edge (it might take 10 years for the edge to be translated into enhanced returns, but it would be an edge all the same). Those who know something about stocks are better off than those who do not know that something. Research that is not published is known only to those who did the research. The market price cannot possibly incorporate all useful information because not all useful information is made public.

There’s No Efficient Market If Not All Investors Are Aware of All Public Information.

What percentage of investors knows about this web site and the Return Predictor? Let’s say that it is one-thousandth of one percent. That means that over 99 percent of investors do not have access to this information. Information that you do not know about cannot affect your investing decisions. Most investors have not seen the information they need to invest in such a way as to bring about efficient prices.

There’s No Efficient Market If Not All Investors Accept Important Public Information.

Of those who know about the Return Predictor, how many accept its claims as true? I’m certain that it is a number less than 100 percent because I have a distinct recollection of seeing on a discussion board a post from a fellow who entertained some doubts. If the claims of the Return Predictor are true, those who do not accept these claims are not able to act on the information provided by the calculator in such a way as to bring about efficient prices. (Conversely, if the claims are not true, those who do accept the claims cause inefficient prices.)

There’s No Efficient Market If Not All Investors Agree on What Action to Take in Response to Public Information.

Say that we were not concerned about all of the people who do not know about the Return Predictor or who do not accept its claims. Taking into consideration only the universe of investors who have the Return Predictor bookmarked and who use photos of the Results Page as the cover for the Christmas cards they send to friends and family, is it possible that the market price is efficient? It is not.

Investing Confused

For information to affect the market price to the extent needed to make it “right” or “efficient,” it must not only be known and accepted, it must also be acted on appropriately. Even the authors of the Return Predictor cannot tell you with certainty how to act on the information obtained through use of the Return Predictor. John and I from time to time discuss this question in e-mails. We agree on many points; we do not agree on some. On some, we both acknowledge that we have more to learn. We don’t know it all and it is highly unlikely that any of the users of the calculator today know it all.

Different users of the calculator are coming to different conclusions as to the strategies to adopt in response to tapping into the information it provides. As new investors learn of the calculator, it is put to new uses and its effect on the market price changes. If the calculator is having one effect at one time and another effect at another time, it cannot be having the “right” effect at all times. The efficient market is an imaginary construct.

There’s No Efficient Market If Investors Do Not Agree on What Information Is Important.

I think that the Return Predictor is a powerful investing tool. Mel Lindauer (co-author of The Bogleheads Guide to Investing) thinks it is a piece of smelly garbage. Who’s right?

For purposes of the argument put forward in this article, it doesn’t matter. If I am right, Mel’s stubborn unwillingness to agree with me re the value of the calculator is causing the market price to go a wee bit off. If Mel is right, my stubborn unwillingness to acknowledge that the calculator is a piece of smelly garbage is causing the market price to go a wee bit off.

For the market price to be “right,” investors would need to be able to know with certainty what information is of value and what information is not of value. The fact that there are disagreements about how best to invest (and I think it is fair to say that the Lindauerhead Lions are not going to lie down with the Bennetthead Lambs anytime real soon) shows that at least some of us do not know with certainty what information counts.

There’s No Efficient Market If Some Investors Do Not Act on Important Public Information That They Accept.

Say that everyone knew how best to respond to the information contained in the Return Predictor. The market price would not be efficient even in those circumstances. Many of the people who used the calculator and learned from it would never get around to changing their stock allocations in response to what they learned. Did you ever fail to make a dental appointment that you knew was needed? Did you ever fail to bring your car in for an oil change in the time recommended?

Information not acted on has no effect on the market price even when the information in some theoretical sense should have an impact.

There’s No Efficient Market If a Large Number of Investors Comes to Believe That There Is An Efficient Market.

Investing Mistakes

A large number of investors have come to believe in the Efficient Market Theory in recent decades. That change in the investing realities affected market prices. For one thing, belief in the efficient market has made large numbers of investors complacent about high valuations. This change in public attitudes about how stock investing works itself disproves the theory.

Before there was a widespread belief in an efficient market, people invested one way. After the belief came to be widespread, people invested another way. The two different ways of investing produced different market prices. Either the earlier way of producing prices (disbelief in the theory) was right or the new way of producing prices (belief in the theory) is right. Both things cannot possibly be so.

There’s No Efficient Market If Investors Become Emotionally Attached to the Idea of an Efficient Market.

Say that a large number not only comes to believe in the efficient market, but becomes emotionally attached to that belief because it enjoys outstanding stock returns during the time-period immediately after it comes to believe in the theory. Such investors would respond differently to criticisms of the theory than investors who merely assented intellectually to the theory (for one thing, they would be less willing to revise their views after being presented with evidence that they are faulty). Again, this would cause a change in prices. Again, the market price could not have been “right” both before and after the time at which the emotional attachment was developed.

There’s No Efficient Market If Investors Are Not Motivated Solely To Make a Profit from Investing.

Say that all investors possess perfect information but not all investors are motivated solely to make a profit from investing. In that were so, the market price could not be efficient. People would be taking actions different from the presumably efficient actions that would follow from acting to enjoy a profit and those actions would be affecting prices, causing prices to be something different from what they would have been had profit-seeking been the only motive with an influence.

Are there people who invest with motives other than to make a profit from investing? There sure are. Many transactions are completed by mutual-fund managers. The primary motive of many mutual-fund managers is to persuade people to invest in their funds. The investment decisions likely to produce strong long-term returns are often different from the investment decisions likely to persuade people to choose a fund (many investors focus on short-term results in deciding what fund to choose).

Even mutual fund managers who possessed perfect knowledge of how to invest effectively would feel pressures to dumb down their investing decisions to remain in business for the length of an out-of-control bull market. In cases in which mutual fund managers make less than optimal choices, the market price is rendered inefficient.

There’s No Efficient Market If Prices Go to Extreme Highs or Extreme Lows.

Can prices go to extreme highs or lows in an efficient market? They cannot. When prices go to extreme highs, the long-term return on stocks drops to levels lower than the long-term return on super-safe asset classes. There is no rational reason to invest heavily in stocks at such times. Why would someone invest heavily in a risky asset class when a better return was available from a non-risky asset class?

The reality is that prices do go to extreme highs and lows. The efficient market is an imaginary construct. That’s the layperson’s way of saying it. If you spend much time hanging around the Big Wheels in the investing advice biz, you’ll sooner or later catch us using the technical terminology generally reserved for insiders. At our professional conferences we might not employ the plainspeech saying that the efficient market is “an imaginary construct.” We might go professional on you and observe that it is “a big bunch of hooey.” Please don’t be intimidated by the lingo. The intended meaning is the same.

Efficient Market Dangers

There’s No Efficient Market If Any Stocks Are Held by Humans.

Humans are emotional creatures. That means that they do not act only in response to information bits. Their decisions are influenced by emotions — fear, greed, envy, panic, all sorts of things.

Even if all information were incorporated perfectly into the market price, the efficient market would be an imaginary construct. Information is not the only influence on prices in a world in which stocks are owned by humans.

The Efficient Market concept is a big bunch of hooey. Tell your friends. Let’s work together to make stock investing safe for humans again!

Note re the Easter Bunny comment: I do not believe that people who believe in the efficient market are dumb. All human beings are flawed. We all do dumb things from time to time. Those of us who have come to believe in the efficient market have done a dumb thing, in my view. It is not my intent to insult those people by pointing this out. My intent in putting forward a comment like the Easter Bunny comment is to get them to stop and think and perhaps reconsider. I am sure that these people have much to teach me and many others about many other aspects of the investing project.

Investing for Humans

Could it be that I am the one who is doing a dumb thing? It could indeed be that that is the case. If you believe that that is so, I hope that you will consider taking some time out of your day to show me where I have messed up. May you say that not believing in the efficient market is as dumb as believing in the Easter Bunny? You may. Please just try to keep it lighthearted enough so that we may remain friends while disagreeing on this investing topic (and please let me know if you ever think that I have crossed the line and permitted my strong criticisms of an investing theory to become personal insults).