Buy-and-hold investing doesn’t work. Those who follow the academic research have known this for decades (it was in 1981 that Yale Professor Robert Shiller published his research showing that valuations affect long-term returns). However, articles explaining the realities of stock investing to middle-class investors remained rare for so long as the taboo on pointing out the flaws of the Passive Investing model remained strong.
Fortunately, the 2008 stock crash and the economic crisis that it brought on has caused a weakening in the taboo on reporting of the realities as revealed by the academic research. Since the crash there has been a flood of articles pointing out that the Efficient Market Theory — the intellectual framework of the conventional investing wisdom of the past three decades — has been entirely discredited.
So far we have not seen talk translated into action; it is still common for “experts” to argue that it is okay for middle-class investors to fail to change their stock allocations in response to big price changes. But change is coming. And the key to overcoming the crisis is spreading the word far and wide about what the academic research of recent decades really says — that buy-and-hold investing is a doomed strategy and that the reckless promotion of this strategy for many years after the flaws in it became public knowledge was the primary cause of today’s economic crisis (this article was posted in November 2009).
The purpose of this article is to spread the word. Set forth below are 19 links to articles explaining why the idea that the stock market is efficient or rational is a myth and why we need to recast the Passive Investing model into something more realistic and prudent and practical and life-affirming.
Link #1 Explaining Why Buy-and-Hold Investing Doesn’t Work :
Rob Arnott: The conventional wisdom of modern investing is largely myth and urban legend.
Link #2 Explaining Why Buy-and-Hold Investing Doesn’t Work:
If Empirical Observation Is Incompatible with the Model, the Model Must be Trashed or Amended, Even If It Is Conceptually Beautiful or Mathematically Convenient.
Link #3 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Economics is a dog’s breakfast of theoretical ideas and alleged causal relationships that are at all times unproven and in dispute.
Link #4 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Since they did not diagnose the disease, there is little popular confidence that they know the cure. What if economics is, actually, at the same level as medicine was when doctors still believed in the application of leeches?
Link #5 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Jeremy Grantham: Greed and reckless overconfidence on the part of almost everyone caused us to ignore risk to a degree that is probably unparalleled in breadth and depth in American history. Even more remarkable was the lack of insight and basic competence of our leadership, which led them to ignore this development, or worse, to encourage it.
Ingenious new financial instruments certainly facilitated and exaggerated these weaknesses, but they were not the most potent ingredient in our toxic stew. That honor goes to the economic establishment for building over many decades a belief in rational expectations: reasonable, economically-induced behavior that would always guarantee approximately efficient markets.
In their desire for mathematical order and elegant markets, the economic establishment played down the inconveniently large role of bad behavior, career risk management, and flat-out bursts of irrationality. The dominant economic theorists so valued orderliness and rationality that they actually grew to believe it, and this false conviction became increasingly dangerous…
Never underestimate the power of a dominant academic idea to choke off competing ideas, and never underestimate the unwillingness of academics to change their views in the face of evidence. They have decades of their research and their academic standing to defend. The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all.
Link #6 Explaining Why Buy-and-Hold Investing Doesn’t Work:
The old-fashioned way to finance business activity is to apply a lot of domain-specific knowledge and form an opinion about the potential returns of an investment opportunity. In other words, the value of a financial asset (and thus the interest rate at which the capital is to be lent) depends on the risk-adjusted returns one expects it to produce in the future.
But the modern way has been to value assets using mathematical models that compute risk statistically, on the basis of historical data. If the value of investments and of real assets (like houses) continues to increase, then the risk models suggest they will keep increasing. That enables people to borrow more and more money against those assets. Stated that way, it’s hard to see how huge asset bubbles could fail to form! There are no built-in brakes to the process.
Link #7 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Warren Buffett: There is so much that’s false and nutty in modern investing practice…There’s this holy writ, the efficient market theory…. Higher mathematics my be dangerous and lead you down pathways that are better left untrod…. The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.
Link #8 Explaining Why Buy-and-Hold Investing Doesn’t Work:
In the search for the “guilty men” responsible for the near-collapse of the global economy, one obvious group of scapegoats has escaped blame: the economists….To see why these seemingly obscure academics deserve to be hauled out of their ivory towers and put in the dock of public opinion, consider why the bankers, politicians, accountants and regulators behaved in the egregious ways that they have. It may be true that all bankers are greedy, all politicians venal, all regulators blind and all accountants stupid. But such personal failings do not explain their behavior in the past few years. After all, bankers do not like losing money and politicians do not like losing power. All these “guilty men” behaved as they did because they thought it made sense.
And why did these greedy bankers and stupid politicians hold beliefs that, in hindsight, seem so ludicrous and self-destructive?…. What the “madmen in authority” were hearing this time was the echo of a debate that consumed academic economists in the 1960s and 1970s – a debate won by the side whose theories turned out to be wrong. This debate was about the “efficiency” of markets and the “rationality” of the investors, consumers and businesses who inhabit them….
So economics is on the brink of a paradigm shift. We are where astronomy was when Copernicus realized that the Earth revolves around the Sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.
Link #9 Explaining Why Buy-and-Hold Investing Doesn’t Work :
Following conventional wisdom has led a generation of investors down the road to ruin. That wisdom had us believing that over the long run stocks produce the highest returns, that a diversified stock portfolio protects you against loss and that the risk of owning stocks is small if you hold them for a long time. We now know that conventional wisdom is wrong.
Link #10 Explaining Why Buy-and-Hold Investing Doesn’t Work:
All three stories can be referred back to the same root: the idea that the market price of a share or other security is somehow true, or at any rate truer than any other price that can be arrived at. That in turn rests on a notion embedded in financial theory for the past half-century, that of rational expectations. Markets embody the balance of considered, informed opinion on likely outcomes. Individuals may be too bullish or bearish, but the market is neither. The two cancel out. A moment’s reflection tells us this is nonsense.
Link #11 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Andrew Smithers: It Is Sad That the Idea That Price Doesn’t Matter…Should Ever Have Become Seriously Considered.
Link #12 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Wharton: The cause of the crisis was models that we use to understand stock investing that “by design, disregard the key elements driving outcomes in real world markets.”
Link #13 Explaining Why Buy-and-Hold Investing Doesn’t Work:
It alarms me to see authorities, like MIT’s normally reliable Baseline Scenario, dismiss economic bubbles as inevitable. It is always tempting to dismiss unexpected events as normal, but a mistake. High reliability organizations, in contrast, track down bad news (Warren Buffett’s “tell me the bad news, the good news will take care of itself”) and stalk the anomalous. Such organizations keep asking people if they have noticed anything out of the ordinary. They praise them for an affirmative answer, and disseminate what they have spotted. The unexpected is a solid clue that your model of the world is in error.
Link #14 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Perhaps Most Scandalously, the Theory Remained Received Wisdom Long After Empirical and Theoretical Arguments Had Demolished It Within the Academic Community…. It Is the Realization That the Financiers Who Came To Grief Last Year Should Have Been Fully Aware That They Could Not Rely On Their Own Models That Sticks in the Memory.
Link #15 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Paul Krugman: Finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings.
Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient….
There was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing.
And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right.
In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.
Link #16 Explaining Why Buy-and-Hold Investing Doesn’t Work:
The British Chartered Financial Analyst Institute Recently Asked its Members for the First Time if They Trusted in “Market Efficiency” – and Discovered that More Than Two-Thirds of Respondents No Longer Believed that Market Prices Reflected All Available Information. More Startling Still, 77 Percent of the CFA Group Also “Strongly” or “Very Strongly” Disagreed that Investors in Aggregate Behaved “Rationally” – in Apparent Defiance of the “Wisdom of Crowds” Idea That Has Driven Much Investment Theory.
Link #17 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Shiller declared in 1984 that the logical leap from observing that markets were unpredictable to concluding that prices were right was “one of the most remarkable errors in the history of economics.”
Link #18 Explaining Why Buy-and-Hold Investing Doesn’t Work:
Peter Bernstein: Everything has fallen apart.
Link #19 Explaining Why Buy-and-Hold Investing Doesn’t Work:
We wonder why funds and banks, full of the best and brightest, have made such a mess of things. Part of the reason is that we have taught economic nonsense to two generations of students.
The Efficient Market Hypothesis (EMH) should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed in it…. Only two hands remained up!