Kent from The Financial Philospher blog and I have been engaging in a bit of back and forth re The Future of Investing (whether Buy-and-Hold was the primary cause of the economic crisis and whether there is a need to begin a transition from Buy-and-Hold to Valuation-Informed Indexing) at the Get Rich Slowly blog today. The relevant comments are #5, #14, #22, #25, #37, #41, #69, and #71 at the thread below:

http://www.getrichslowly.org/blog/2010/02/01/is-the-economy-improving-views-from-everyday-folks/?cp=1

The issues being discussed are so big (and exciting!) that they showed the potential to take the thread off course of its primary topic (the economic crisis and whether it is coming to an end soon). So J.D. asked that we move the discussion here.

I am of course fine with that and thought that I should open a thread here for use by anyone interested in talking over a bit the questions raised in those comments. It may be that there is no one today who wants to do so. I of course understand. The purpose here is not to push. The purpose is merely to provide the opportunity in the event that there are some who would like to take these important (in my view!) discussions to the next stage.

These discussions are really a follow-up to the fine thread we generated last week:

http://www.getrichslowly.org/forum/viewtopic.php?f=2&t=4882

Not all who participated in that one agreed with the argument that I advanced in the thread-starter, to be sure. But I do think that it can fairly be said that there was a lot of good back-and-forth on some very important questions provided.

So -- Shoot! (not really, though!)

Rob

Could you explain the mechanism how investors who follow a buy-and-hold approach caused the recent economic crisis, Rob?

I ask because by my logic those who buy, hold, rebalance (that last part is key!), are going against the herd.

Consider an investor who maintains 60% in stocks and 40% in bonds. When stocks rise dramatically, this will cause the percentage in stocks to rise. Thus the next course of action is to SELL to bring stocks back down to the 60% target.

Conversely, when stocks fall dramatically, this will cause the percentage in stocks to fall. Thus the next course of action is to BUY in bring stocks back up to the 60% target.

Thus in bull markets, Buy-and-Holders are net SELLERS. And in bear markets, Buy-and-Holders are net BUYERS.

Therefore, Buy-and-Holders do NOT contribute to stock bubbles.

Schroeder

I ask because by my logic those who buy, hold, rebalance (that last part is key!), are going against the herd.

Thanks for asking that question, Schroeder. My sense is that many feel as you do.

I think it is fair to say that rebalancing is going against the herd. And that's indeed a good thing. My view is that it is not good enough to get the job done. I do NOT say that Buy-and-Holders are the most reckless investors out there. That's not even close to being so. I am saying that the Buy-and-Hold idea is the thing that causes most of the trouble. I will try to explain the distinction that I am making in my comments below.

Investing in stocks at times of reasonable prices is like driving a car down the highway at a speech of 65 miles per hour. This is not a terribly risky activity. We all do it all the time.

Investing in stocks at times of insanely dangerous prices is like driving a car down the highway during a snowstorm at a speech of 65 miles per hour. That's asking to get killed.

The Buy-and-Holders didn't create the snowstorm. They are not to blame for the problem. The problem is really just human nature. We all have the power to vote ourselves a raise by agreeing to increase stock prices beyond what is justified by the economic realities and there are times when we just cannot resist doing so.

The question is -- What is the possible brake on this behavior? How do we resist the temptation to destroy our markets by bidding prices up to unsustainable levels?

The answer is -- price discipline. I believe that it is Job #1 for all investing experts to be constantly preaching the importance of price discipline. If most experts did this, stocks could never get to insanely dangerous price levels and the risk of stock investing would be reduced by about 80 percent.

But look at what Buy-and-Hold does. It tells people that there is no need to change stock allocations regardless of how high prices go. Could anything be more dangerous?

And it is not just the message that is dangerous. The people giving the dangerous message are the sort of people that give the messages they put forward credibility. We're not talking about Jim Cramer here. We're talking about people who purport to be basing their investing advice on academic research. Buy-and-Hold is promoted as prudent investing. It appeals to people who are seeking to avoid Get Rich Quick schemes. When we persuade the people who by inclination prefer prudent investing to throw out all price discipline, we are pretty much in the soup. When the people who want to be safe are sticking to the same stock allocation despite huge price changes, you can pretty much count on the fact that the hot-stock-tip guys are doing the same or worse.

We need to insist on price discipline. It's not easy, It's hard. The Buy-and-Holders don't even try. They claim there is no need. They say that it is just fine to stick at the same stock allocation at all price levels. They call this "Staying the Course."

It's not Staying the Course to continue driving 65 miles per hour when the roads are icy. It's going from following a reasonably safe practice to following an insanely dangerous one.

There are a lot of wonderful ideas in the Buy-and-Hold package of ideas. But this one idea -- the idea that there is no need for price discipline -- is a loser (in my view!). I see that one idea as being so bad that it is poisoning all the rest. My aim is to save the good ideas by being willing to throw overboard the idea that is so bad that it ruins all the rest.

When you tell people that "timing doesn't work," you are telling them that "price discipline doesn't work." I advocate doing just the opposite. I advocate telling people that price discipline is required and that therefore timing is required. I of course don't advocate short-term timing (which really doesn't work). But I say that long-term timing is required just as much as it is required of a driver that he be willing to slow down when the road is icy.

Rob

I am trying to understand your message, Rob. I picked this part out. And it seems we are agreeing . . .


This is what I wrote above. Buy-and-Holders are going against the herd by being net sellers in bull markets and net buyers in bear markets. So how can they be blamed for the problem of stock bubbles?

Schroeder

"We need to insist on price discipline."

Your frequently stated insistence on controlling other peoples private behavior, that we all carry out for the most personal and private of reasons, would be scary enough if anything else you said made sense.

As it is, it just seems like a displaced Napoleon Complex looking in vain for it's lost horse.

I didn't realize that the stock market had anything to do with the economic collapse. It was derivatives markets in which banks invested too heavily. It was institutional investors that presented the systemic risk. Individual investors had nothing to do with it.

Am I misunderstanding your primary assertion?

Buy-and-Holders are going against the herd by being net sellers in bull markets and net buyers in bear markets. So how can they be blamed for the problem of stock bubbles?

You're looking at the worst strategies out there and saying "Buy-and-Hold is not as bad." I'm looking at what I believe really works and saying "Buy-and-Hold doesn't measure up." That's the difference between us, Schroeder. Instead of aiming to be not as bad as some others, why not aim to be the absolute best you can be?

The people who came up with the Buy-and-Hold concept did a wonderful thing by making investing advice objective for the first time. That took things out of the realm of pure opinion. I have great respect for these people for having done this.

I believe, though, that, once you take that step, you incur obligations to always report the objective realities accurately. It is just not an objective reality anymore that the market is efficient. There are still people who say this and it is fine to report that reality. But it is also a reality that there are people who say that the market is not efficient. That needs to be reported as well.

In the earlier thread, Jericho made the point that he is an economist and he thinks I am wrong. Fine. I think that is fair as far as it goes. But since Jericho is an economist he must know that the literature now includes the reports of many economists who say that I am right. He should report that as well. He should tell people that "I am one of the many economists who believe that Rob is wrong but there are also a good number today who believe that Rob is right." If he said it that way, people could hear both sides and make up their own minds.

The problem with the Buy-and-Hold Model is not that it got some things wrong along the way. Any possible model would have gotten some things wrong. The problem is how those who advocate this model have responded to the evidence that they got some things wrong. They have not responded by backing down a bit on the level of confidence they express in their beliefs. They have responded with ever increasing dogmatism. This dogmatism is driving us over a cliff.

I don't know everything about investing, Schroeder. Neither do you. I should be learning from listening to you and you should be learning from listening to me. There should be 100 percent agreement on this point. But there isn't. Why?

The problem is that when the Buy-and-Holders made investing scientific they came to believe that they had figured it all out and the possibility of error did not exist anymore. No! The possibility of error always exists for so long as it is humans who are running the show.

When Jim Cramer says something, he is just stating an opinion. His opinions really only affect people who listen to Jim Cramer. That's not so with the Buy-and-Holders. The things that Buy-and-Holders say are reported as if they are truth. They are delivered with an air of conviction as if they may not be questioned. It is this dogmatism that I am challenging. I am saying that it is unwarranted.

Humans have always had an inclination to bid stock prices up to dangerously high levels. This has been going on since the beginning of time. What Bogle added to this mix is the idea that there is nothing wrong with doing this and that there is some sort of "science" that says so. There is no science that says this. Smart people once thought there was but they were mistaken. They need to chill.

People often ask me "Rob, why can't you just present your ideas on investing without putting down the Buy-and-Holders?" I'd love to be able to do that. The reason why it doesn't work is that the Buy-and-Holders have take up all the oxygen in the room. As soon as I start describing to someone the price level at which they need to lower their stock allocation, a Buy-and-Holder jumps in and says "You Can't Time the Market!" And they insist that this idea not be questioned, that it be accepted as science.

If it is all just opinion, that's fine. Then there is no conflict. Then I can present what I think it is a better way and there's no trouble.

If the Buy-and-Holders are going to insist that their ideas are science, then all of us who believe we have better ideas are forced into refuting the claims as bad science. The Buy-and-Holders are demanding to be refuted before the conversation can go forward.

You tell me, Schroeder -- Is it science? If it is not, you and I have no problem. We are just two people with different opinions on how to invest.

If you say that your ideas are science, then I need to refute the scientific validity of your ideas in order to make the case for my ideas. There's no other way possible to proceed.

Buy-and-Hold caused the bubble by taking all the oxygen out of the room and making it impossible for people with other viewpoints to present their case effectively. It is the dogmatism that has become characteristic of Buy-and-Hold that led us into this economic crisis.

Rob

I didn't realize that the stock market had anything to do with the economic collapse. It was derivatives markets in which banks invested too heavily. It was institutional investors that presented the systemic risk. Individual investors had nothing to do with it. Am I misunderstanding your primary assertion?

My assertion is that the promotion of Buy-and-Hold was the primary cause of the economic crisis.

Stocks were overvalued by $12 trillion in 2000. Overvaluation always disappears from the market over time. Bogle describes this as an "Iron Law" of investing. So anyone who cared to knew in 2000 that we were going to in coming years see $12 trillion disappear from the pockets of investors. What would you expect to have happen when $12 trillion of spending disappears from a consumer economy? Of course this brought on an economic crisis. What the heck else ever could happen?

There are lots of things that could have triggered the collapse. It could have been a rise in gas prices. It could have been a declaration of war. It could have been an assassination. It could have been a terrorist attack. It could have been a mortgage meltdown. It could have been derivatives. Any of these things could serve as the straw that broke the camel's back.

But the true cause is the idea that stock prices do not matter, that we can continue to bid prices up, up, up and not destroy our economy by doing so. The portion of your portfolio that represents overvaluation is not real, it is only temporary money. If you had $300,000 in your portfolio in January 2000, you have $100,000 of real wealth and $200,000 of cotton-candy nothingness (stocks were priced at three times fair value at the time). You didn't know that, did you? Because you didn't know that, you felt free to spend money on all sorts of things that you would have known you could not afford if your portfolio statement had been showing the proper numbers. Huge amounts of middle-class money were misallocated.

I am saying that we should begin reporting the proper numbers. They were reporting the DOW as being at near 12,000 back at the top of the bubble. They should have been saying "the nominal DOW value is 12,000 but the true value is one-third of that, or 4,000." Then people would know how much money they really had and they would be able to make informed decisions about what to buy and whether to start businesses and whether they had enough to retire and all this sort of thing.

We need accurate information about how much money we have to be able to participate effectively in our consumer economy. It's absolutely necessary for the system to work. But we cannot get that information for as long as there are people saying that the market always prices stocks properly, that the market is efficient.

Again, if the market really were efficient, everything else that the Buy-and-Holders say would follow. I fully understand how they came up with what they did. I do not question their intent.

What I question is the idea that the market is efficient, that the market prices stocks properly. I say that the market does not do this.

Nobody had to believe me. There is room for differences of opinion on this point. But there is not even a chance that the new ideas can gain popularity if we do not even permit them to be expressed. If both sides are told, people can make up their own minds. Today, only one side of the story may be told. That means that, if that side happens to be in error, we are doomed.

If you consider that the market was overvalued by $12 trillion, you don't need to look any further for the cause of the economic crisis. That one fact told you years in advance that a huge crash and an economic crisis were coming. Please do not think that I am the only person who believes this. If you search the internet, you will find many smart people who believe all that I am saying here.

I am saying that people who hold these views should be permitted to participate at all boards and blogs that discuss investing. People who want to believe them should believe them. People who prefer other ideas should believe those other ideas. That's the way that it works with every issue that I know of other than Buy-and-Hold.

If the market truly is not efficient, we have a perfectly reasonable explanation of the economic crisis available to us. It happened because we bid stock prices up to insanely dangerous levels and the idea had caught on that there was no need to lower one's stock allocation in such circumstances.

I blame Buy-and-Hold and the dogmatism that has come to be associated with it. That is my take. Buy-and-Holders have become so intensely dogmatic that they do not even permit other ideas to be expressed. They have created a closed system of thought. Closed systems cannot be challenged. Which means that they cannot be improved. In cases in which closed systems really are in error, the only way that the errors can be fixed is through a complete collapse. This is what I believe we are living through today -- an economic collapse brought on by the insane level of dogmatism that has come to be characteristic of the Buy-and-Hold model for understanding how stock investing works.

People who expose you to other points of view are not your enemies. People who expose you to other points of view are your friends. Many Buy-and-Holders do not see it that way. I think they are wrong to be so dogmatic. In the event that they really are wrong, the consequences of their dogmatism are going to be catastrophic. If you are going to rule out the discussion of any other possibilities, you had better be really, really, really sure of what you say before you say it.

I don't think that any of us humans can ever afford to be quite that sure of ourselves.

Rob

it just seems like a displaced Napoleon Complex looking in vain for it's lost horse.

You're not even trying, Lost Opportunity.

I believe that you are capable of better. I ask that you reach down deep and make an effort to participate here in a constructive and positive and life-affirming way.

Rob

Rob, I think this section really highlights one of the key problems most of us have with your outlook. You accused "Buy-and-Hold'ers" of stating opinion as fact, as scientific dogma, yet you just did something similar yourself. You said:

"The nominal DOW value is 12,000 but the true value is one-third of that, or 4,000."

The problem, Rob, is the definition of the words "true value." What is "true value?" How is it determined? The thing is, the stock market is nothing more than one great, big auction. Sure, there are lots of guidelines and rules of thumb for establishing a company's value ("2 times annual earnings", "1.5 times earnings plus tangible assets," etc.), but that's just it - they're just guidelines. At the end of the day, the individual investors bidding on the stocks will choose their own methods of valuation. If I think a company's "value" is 2 times its annual earnings, but you're willing to pay 3 times earnings, who is right? Who's to say I'm right and you're wrong, or vice-versa?

Let me put this another way. What is the "true value" of a home? Is it the value of the raw materials used to construct it, plus the man-hours of labor used to build it, multiplied by the going rate of unskilled labor? How do you value the land it's sitting on? After all - it's just dirt. It's been sitting there since before the concept of money even existed. Nobody bought it from anyone, it was just there. What's its value? Do you factor in the local market rental rates? How does proximity to bus routes affect its value?

Now here's where it gets tricky, Rob. Say you look at all those things and decide the house is worth $250,000. However, when I look at it, I calculate that it's worth $275,000 to me, because I don't own a car, so I assign more value to the fact that it is near public transit (you, however, have a car. So you don't care that it's on a bus route, and thus that factor is unimportant to you). Consequently, the house is worth more to me than you.

Now here's the kicker: which of us is "right?" What's the "true value" of the house? If you and I both bid on it, the sellers would obviously sell to me instead of you, because I'm offering a higher price. Would you then conclude that the house is "dangerously overvalued?" Would you then advise the neighbors to start selling their own houses, because the local market is "dangerously overvalued?"

I'm very curious how you reconcile this obvious contradiction against your own position on the "true value" of stocks. How is the above situation any different than your own views on stock valuation? And if it's not, can you now see why many of us hold the position that it is impossible to discern a "fair value" for stocks, since the stock prices themselves are entirely subjective, and every investor has their own criteria for establishing what they're willing to pay for any given stock?

Can you now see the futility of your system?

The economic recession of 2008 indeed had nothing to do with individual investor behavior in the stock market. DTR hits many of the correct points and in addition we have to add in the exploitation of information in the mortgage industry (the whole bad loans thing) which, while not the primary culprit, was a rotten apple in a barrel full of apples. I'm going to state this as fact, being as I have the whole "economist who does this stuff for a living" schtick.

And Rob,
You're essentially asserting that stock price gains aren't real gains. To this I counter with a very specific counter-example. I was among the first-buyers of Netflix stock. Since that time their revenue and profit margins exploded, making the company worth alot more. It grew. Their stock price increases because their worth has gone up, expected future earnings are up, and more people want to own the stock versus other companies.

The 10,000 I invested at 10 a share back in 05 or 06 now stands today at 62 dollars a share. Are you in fact stating that the 50,000 gain is not real? Because 1 seven dollar transaction says it is.

My honest opinion Rob, is that I still don't understand how you define "Buy and Hold" or how it specifically is the most awful thing in our financial system, or how its the most important linchpin to be railing against. I don't feel you've demonstrated any quantitative evidence to back up this assertion. You didn't respond much to the fact that Buy and Hold creates a counter-cyclical buying pattern (tending to not create bubbles) I feel, honestly, that you've picked on a behavior and a term that you've defined to mean something very different than its colloquial meaning.

Finally, I'm certain that JD didn't request this thread, just that it be moved off the main site. Carry on.

You accused "Buy-and-Hold'ers" of stating opinion as fact, as scientific dogma, yet you just did something similar yourself.

You're right about this, Kombat. We're starting from a different set of fundamental beliefs. I am saying what truly follows from my set of fundamental beliefs and you are saying what truly follows from your set of fundamental beliefs. You are being sincere and I am being sincere.

What to do?

Bill Sholar and I became friends when I was posting at Motley Fool. He wrote one of the blurbs that appear on the back cover of my book. He developed the FIRECalc retirement calculator, which I say is analytically invalid. He eventually made a decision to ban me from the Early Retirement Forum (he owned the forum at the time). He was pained to do this because he was a friend of mine and because he knew that I was sincere and that there were a number of people at the forum who agreed with me. One of the comments he offered to justify the banning was that me posting at that board was like a Methodist running into a meeting of Baptists and saying "I have found the true religion!"

That's truly funny because it gets at what is really going on here. People have come to think of Buy-and-Hold as a faith. They don't care anymore whether the academic research supports it or not. They want to believe and that's that. They get angry at anyone who undermines their confidence. And there is obviously no question but that I am trying to undermine people's confidence in Buy-and-Hold.

I don't think that it is a good idea to turn your investing beliefs into a matter of religious faith. That's the key point.

I'll tell you a story about another friend of mine, Brian. Back in the late 1990s, I used to have lunch with Brian several times a week and we would talk about this stuff. I was going with a zero stock allocation and stocks were going up by 20 percent or 30 percent a year. Often at the end of a conversation, Brian would turn to me and say "You understand that you are nuts, right? I just want to be clear that you get that much." But it was done in a friendly way. Then, when stocks crashed in 2008, Brian sent me an e-mail saying "it looks like you were right afterall."

You and I have different views, Kombat. That doesn't have to be a bad thing. It can be a good thing. We can learn from each other. And others can learn from listening in to our interactions.

You're probably not going to change your mind in a day or two or three. And I am not either. The differences here are of so fundamental a nature that it takes time for people to sort through all the issues and make changes in their viewpoints. That goes for people on all sides. That goes for both of us.

The dogmatism that I am finding fault with is the dogmatism that says "I cannot be friends with you if you do not believe in Buy-and-Hold" or "if you do not support Buy-and-Hold, you are a troll," or "I will support efforts to have you banned unless you say that Buy-and-Hold works." You are absolutely right to stick to your guns re what you believe. You are wrong if you cross the line and make people with other views feel uncomfortable posting here.

There are people reading these words today who agree with me but who are afraid to post because of the tone they see in some of the posts directed at me. I know that this is so because of the experiences that I have had at many places. I have had bloggers write me and tell me that they think I make great points but that they feel they need to ban me because Buy-and-Hold dogmatics will destroy their blogs if they permit honest posting. That is evidence of a problem.

You really do believe in Buy-and-Hold, Kombat. And so you should of course say that when you post. I really do not believe. So I should say that. We both should respect the right of the other to say what the other truly believes.

That's the point I am making about dogmatism. I do believe that my investing approach is scientific, just as you believe yours is. I respect you for believing what you do, understanding that you just come from a different set of life experiences that has caused you to hold these beliefs. I am asking that you come back at me with the same attitude. I don't like feeling that I am on trial when I post here. I want to be able to disagree with your views on investing while remaining your friend.

Please tell me if that works for you Kombat. It would make me feel better if you could say that. I think that's the key to getting things on a good path. I respect you and I like you for what you for the help you are trying to provide people by the posting you do here Do you respect and like me for the help that I am trying to provide people by the posting I do here?

Rob

I'm very curious how you reconcile this obvious contradiction against your own position on the "true value" of stocks.

You are getting right down to the core of it with these words, Kombat. This is the entire shebang.

Buy-and-Holders say that the market price is the best estimate of the real value.

I say that the market price adjusted for overvaluation or undervaluation is the best estimate of real value.

That's our entire difference.

You are saying that the market can be trusted to get it more or less right. I am saying that the market can be trusted to get it more or less right if you adjust for valuation but not if you fail to do so.

To understand my point of view, you need to reflect for a moment on what overvaluation is. The market is capable of including everything else in its estimate of true value. But the market is by definition not capable of including misvaluation in its estimate of true value. If the market could incorporate into its price the effect of misvaluation, there would not be any misvaluation.

You are trusting the market to get it all right. I am trusting the market to get it all right but for misvaluation. The reason why I see misvaluation as something different from every other factor that affects stock prices is that it is impossible for a market to incorporate misvaluation into its pricing. Asking a market to do that is like asking a person to tell you how biased he is in his own opinions; no one is aware of his biases or else he would not let them influence him any more and they would no longer be biases. The market wants to get it right. But we need to help it along by insisting that adjustments for misvaluation be included in reports of the market price.

Rob

I'm going to state this as fact, being as I have the whole "economist who does this stuff for a living" schtick.

I do not think it is a good idea for economists to state things so dogmatically, Jericho. Part of the idea of becoming a professional is to understand the full range of thought bearing on examination of a question. I know that there are economists who agree with me as I have read them and linked to them. Can you acknowledge that this is so?

If different economists have totally opposed positions on such a core question, economics is not a science, right? So none of us should feel bound to accept what you say as proven truth. You have studied these matters more than most of us, that's fair to say. And there are a good number of very smart people who agree with you, that's also fair to say. But there are other smart people who have studied these matters and come to very different conclusions. So we all have a right to hold different viewpoints and there is nothing even a little bit unscientific about our decision to do that.

You're essentially asserting that stock price gains aren't real gains.

I am saying that stock price gains that push the price beyond fair value are not real gains. By definition. If the gains were real, the stock would not be overvalued. The word "overvalued" means that the price does not reflect reality. That's the concept being signified.

I was among the first-buyers of Netflix stock.

You're talking here about an individual stock. I am talking about the price of a broad index. Very different realities apply.

To know whether a particular stock is overvalued, you would need to know a great deal about the underlying company's future prospects. It is very hard to know these things about a particular stock.

To know whether a broad index is overvalued, all you need to know is whether the price being charged for the index is larger than the amount of earnings that it can realistically be expected to generate. The long-term earnings of a broad U.S. stock index are highly predictable. So it is not a difficult task to say whether a broad index is overvalued or not.

Finally, I'm certain that JD didn't request this thread, just that it be moved off the main site.

J.D. is trying. That's the point. J.D. is certainly not convinced that I am right on these questions. But he is suggesting a way that they could be discussed and that some of the friction we have seen evidence itself in comments posted to the blog could be dissipated. I think we should applaud him for at least making that effort and do what we can to take advantage of whatever opportunities are presented to us to take a sad song and make it better.

Rob

Whether Buy-and-Hold does or does not measure up does not have any bearing on the point I stated. "Measuring up" does not counter my point that Buy-and-Holders are going against the herd by being net sellers in bull markets and net buyers in bear markets.


This is one man's opinion. I see no evidence that Buy-and-Holder took all the oxygen out of the room and thereby made it impossible for people with other viewpoints to present their case effectively.

There are many, many people who make their case for the way they invest. Anyone can read their viewpoints. You cite Rob Arnott as an example of another viewpoint. Does Arnott make his case in an effective manner?

Schroeder