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
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.
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.
The third reason why the conventional stock market investing advice must change is that it is rooted in a fundamentally flawed understanding of what stocks are.
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.
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.
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.
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
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!
more about why I expect we will soon see a revolution in stock market investing advice,
please take a look at this article on “The Famous Robert Shiller Stock-Market Prediction.”
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My Beef With Bull Markets
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