Wednesday, 10 February 2010

New Investing Idea: The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model

The core Buy-and-Hold claim is that changing one's stock allocation in response to big price changes is not necessary for long-term investing success.

The Rational Investing Model encourages investors to take price (valuations) into consideration when setting their stock allocations.

History of Buy-and-Hold approach

Buy-and-hold approach is when investors maintain the same stock allocation at all times, irrespective of the market valuation.

Most middle-class workers have long had a fear of investing in stocks because of the big losses associated with this asset class at times of stock crashes. The promise of a scientific, long-term approach held great appeal. Few middle-class workers studied Buy-and-Hold to the extent needed to understand where the ideas came from or why they were supposed to work. But most quickly grasped the essential point being promoted -- this was responsible investing. Buy-and-Hold became popular because it was viewed as being a rejection of the Get Rich Quick thinking that had given much investment commentary a bad name.

Why Buy-and-Hold can never work.

It's easy today to explain why Buy-and-Hold can never work. The root idea is preposterous (but not obviously so to those who have not yet seen through it -- there are many smart and good people who possess a strong confidence in the concept). For Buy-and-Hold to work, valuations would have to have zero effect on long-term returns. Stocks would have to be the only asset class on the face of Planet Earth of which it could be said that the price paid for the asset has no effect on the value proposition provided. This cannot be. Price must matter. And if price matters, investors should not be going with the same stock allocation at times when valuations are insanely high as they do when stocks are fairly priced or low priced. Buy-and-Hold defies common sense.

The science of investing

The science of investing showed that short-term forecasting does not work and that a long-term focus is needed. The science appeared at the time to suggest that a Buy-and-Hold strategy (sticking to the same stock allocation at all times) makes sense.

The science did not prove that Buy-and-Hold works. The Greatest Mistake in the History of Personal Finance took place when the academics jumped to the hasty conclusion that the fact that short-term timing does not work necessarily leads to a conclusion that Buy-and-Hold is the only rational strategy.

But Shiller's 1981 research (confirmed by a mountain of research done since then) shows that overvaluation is a meaningful concept. Shiller showed that stocks offer better long-term returns starting from times of fair or low prices than they do starting from times of insanely high prices. Even many Buy-and-Hold advocates acknowledge today that valuations matter. William Bernstein says that valuations affect long-term returns as a matter of "mathematical certainty."

The market must ultimately be efficient, as the academics responsible for the Buy-and-Hold concept claimed. Yet the academic research of the past three decades shows conclusively that the market is not immediately efficient. What, then, is the full reality?

The full reality appears to be that the market is gradually efficient, not immediately efficient. It is investor emotions that determine market prices in the short term. But it is economic realities that determine stock prices in the long term (after the completion of 10 years of market gyrations or so). If the stock price rises too much higher than the price justified by the economic realities, opportunities open up for competing businesses to obtain the same assets on the cheap (relative to the market price assigned to them) and thereby to create a new business with the same profit potential as the overvalued one and thereby to pull the value assigned to it by the stock market down to reasonable levels. The market does indeed insure that stocks are priced properly. But it does not do this in an instant. The process can drag out for 10 years or even a bit longer.

What really works:  successful long-term investing requires long-term market timing

The strategic implications are earth-shaking. It turns out that we have been telling millions of middle-class investors precisely the opposite of what really works in stock investing. Since the market sets the price improperly in the short term and properly in the long term, successful long-term investing requires market timing (not the discredited approach of short-term timing, but long-term timing, which the historical data shows has always worked). The key to long-term success is to disdain the idea of sticking with the same stock allocation but instead always to be certain to adjust one's stock allocation as required by changes in the valuations assigned to the broad market indexes (only one allocation change every 10 years is required on average but it is essential that long-term investors make this change -- Buy-and-Hold never works in the long run because it argues that this change is not necessary or even that it is a good idea not to make the allocation change).

Discarding the Buy-and-Hold Era and adopting the Rational Investing Era

There is one step required before the transition from the Buy-and-Hold Era to the Rational Investing Era (The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model -- it is described in some depth in articles and podcasts available at the site) can begin in earnest. We need to persuade the many experts who advocated Buy-and-Hold to acknowledge the mistake and to thereby launch a national debate on what really works in stock investing. As of today, an institutional interest in preserving the status quo and avoiding the need to acknowledge mistakes has worsened the economic crisis and threatened to bring on a Second Great Depression.

We need a national debate on what works in stock investing. Buy-and-Hold advocates should of course be part of that debate. Buy-and-Hold advocates are smart and good people and have developed many rich insights despite the mistake they made about the core Buy-and-Hold claim (that changing one's stock allocation in response to big price changes is not necessary for long-term investing success). But we need a debate in which Buy-and-Hold advocates drop the pose of perfect understanding that has kept us from exploring new insights for so many years now. We need to see an openness to new investing ideas if our economic and political systems are to survive today's crisis. We need to rebuild optimism for the future by partaking in a fresh start in our effort to discover how stock investing works, We need to put aside those of the old rules that no longer work and replace them with better-informed new rules that do.

The Implication of moving from the Buy-and-Hold Investing Model to the Rational Investing Model

Many have lost sight of the point of investing analysis -- to help middle-class people finance their retirements. All this needs to change if our way of life is to survive the inevitable collapse of the Buy-and-Hold Model.

Our hope lies in coming to see the move from the Buy-and-Hold Investing Model to the Rational Investing Model (the Rational Model says that investors must consider price when setting their stock allocations) not as an investing question or an economics question but as a political question. We have a long tradition in this country of free speech. Free speech is permitted in our discussions of baseball and novels and nutrition and fashions. It should be permitted in discussions of the flaws of the Buy-and-Hold Model as well.


Buy-and-Hold can never work. But many of the insights developed by the smart and good people who brought us the Buy-and-Hold Model can do wonderful things to help millions when incorporated into a model that does work -- the Rational Investing Model, a model that encourages investors to take valuations into consideration when setting their stock allocations.

1 comment:

Rob Bennett said...

This is Rob Bennett, author of the Google Knol on "Why Buy-and-Hold Investing Can Never Work."

Thanks for sharing some of the ideas set forth in the Knol with your readers, BullBear.

If you or others have questions, I'm happy to help out to the extent that I am able.