Our common sense tells us to lower our stock allocations when prices go too high. That’s the only realistic investing strategy.
So why do so many middle-class investors resist the call and take on excessive levels of risk just because other investors have elected to bid stock prices up to unsustainable levels? In most cases, it’s because there are other less-friendly voices objecting to the common-sense plea.
Objection #1 to Following a Realistic Investing Strategy — Short-Term Timing Doesn’t Work
You mention that you are thinking of taking your next vacation at the beach. A friend responds that he doesn’t enjoy hiking in the mountains all that much.
You ask the man at the cash register for a pack of chewing gum. He says that he’s fresh out of sausage biscuits.
You ask your wife if she knows whether it is likely to rain tomorrow. She says that she heard that the Fed is going to raise interest rates.
In our non-investing lives, we are able to recognize absurdly irrelevant responses for what they are. If only the same were so in InvestOWorld. In InvestOWorld, if you suggest that it’s a good idea for long-term investors to lower their stock allocations when price get out of hand, you are all but certain to be met with references to 20 experts who have noted that short-term timing doesn’t work.
There is indeed a good bit of evidence that short-term timing doesn’t work. So? There is also a wealth of evidence that long-term timing does work. So long as an investor seeking to follow a realistic investing strategy by engaging in long-term timing (making a change in his stock allocation with no expectation that it will pay off for one or two or three years or longer) understands that short-term timing does not work, there is no reason why he should even taken into consideration the evidence that short-term timing does not work. This is a completely irrelevant investing reality.
This objection has great power. If anything, the strength of the case against short-term timing is a point in favor of long-term timing; the same historical data that shows that short-term timing has never worked also shows that long-term timing has always worked. Still, many investing “experts” are sloppy with their use of the word “timing;” they fail to make the critical distinction between the type of timing that works and the type of timing that does not work. Many investors do not have the time or inclination to study these sorts of matters on their own and fall victim to the word games employed by those more interested in selling stocks or their own “expertise” than in promoting a realistic investing strategy.
Objection #2 to Following a Realistic Investing Strategy — Most Other Investors Don’t Lower Their Stock Allocations When Prices Are High
The great irony of stock investing is that, if most investors followed a realistic investing strategy, we wouldn’t see out-of-control bull markets or out-of-control bear markets. If investing were primarily a rational endeavor, prices would never reach truly absurd levels.
Investing is primarily an emotional endeavor. Stocks are least risky when most middle-class investors see them as full of risk. Stocks are most risky when most middle-class investors see them as virtually risk-free.
Still, many of today’s investors take comfort in the knowledge that there have been few times in history when investors thought that U.S. stocks were as free of risk as they are today.
Objection #3 to Following a Realistic Investing Strategy — Most “Experts” Pooh-Pooh the Idea of Keeping One’s Risk Level Constant By Selling Stocks When Prices Get Too High
Surely the experts know better than you, right?
No, not right.
The experts may know more about how to keep commissions up than you do. The experts may know more about how to remain popular among the majority of investors than you do. The experts don’t see it as their primary job to protect your life savings. They see that as your job. Remember Dylan’s line in “Just Like Tom Thumb’s Blues”: “The cops don’t need you and, man, they expect the same.” That’s how it works with most investing experts.
You need to start seeing it as your job too. The experts have no intention of bailing you out when you suffer the losses likely to follow from following a less-than-realistic investing strategy. Listen to what the experts have to teach you, by all means. Always be sure to put what the experts tell you through a common-sense filter, however. Your common sense isn’t trying to sell you something.
Objection #4 to Following a Realistic Investing Strategy — It’s Silly to Think that the Historical Stock-Return Data Can Tell Us Something About How Stocks Will Perform in the Future
Just about every investing strategy features claims rooted in findings developed from an examination of the historical stock-return data. How do we know that stocks are generally a fantastic asset class? By looking at the historical data. How do we know that buy-and-hold investing is the way to go? By looking at the historical data. How do we know that stock investing is less risky for those with a long-term focus? By looking at the historical data.
So it shouldn’t shock you to learn that the historical data tells you when stocks offer a strong long-term value proposition and when stocks offer a poor long-term value proposition. It shouldn’t, but it does. I was talking to my brother the other day about the wonders of the Stock-Return Predictor (see tab at left). My own brother expressed skepticism as to whether it is possible to predict long-term returns effectively. The Goons have infiltrated my own family!
It’s the same historical data that tells us all that other stuff that also tells us that stocks offer a dubious long-term value proposition when prices reach the levels that apply today (this article was posted in July 2007). There’s a voice within each of us that tells us that the same historical data that guides all of our other investing strategies may safely be ignored when it warns us of the dangers of failing to respond to high prices in a sensible way. That’s the voice of the gambler, not the voice of the common-sense long-term investor.
Objection #5 to Following a Realistic Investing Strategy — There’s Not Enough Data to Make Precise Predictions About How Much Those Who Ignore Common Sense Will Be Hurt By Doing So This Time
There’s no such thing as too much data. It would be nice to have more data. The reality remains that there is enough data for us to make statistically valid (but not precise) predictions about how today’s valuations will affect the stock returns we will have obtained at the end of the next 10 years.
It’s a sensible voice telling us to make note of the lack of precision of the predictions. It’s not a sensible voice telling us to ignore the predictions.
Objection #6 to Following a Realistic Investing Strategy — Things Can’t Be As Bad as the Historical Data Indicates
The historical data paints a bleak picture for those who fail to heed the message of the historical data. Things don’t look nearly so bad for those following a common-sense investing strategy.
If you see drops of water coming down from the ceiling of a room in your house, the common-sense response is to take this as a sign that repairs are needed. Ignore the need for repairs, and the outlook is indeed bleak. Tale reasonable steps promptly, and there’s no reason to think that anything so terrible is going to happen.
It’s not the historical data that makes things bleak for those overinvested in stocks today. It’s the voice within that causes those overinvested in stocks today to fail to take appropriate action to deal with the problem.
Objection #7 to Following a Realistic Investing Strategy — Acknowledging that Valuations Matter Means Acknowledging that the Real Value of Today’s Stock Portfolios Is a Good Bit Less than the Newspaper Numbers Indicate
This is the big one. Most middle-class investors are worried about having enough saved to finance a decent retirement. Most of us feel that we are barely keeping our heads above water. The last thing that we want to hear is that our stock portfolios are not worth as much as we have come to believe they are worth.
Your stock portfolio is not worth what you have come to believe that it is worth.
I know you don’t want to hear it. I get that message loud and clear. It’s my job to tell you the reality all the same.
It is only by knowing the reality that you can take effective action to protect yourself from a price drop. Sell some stocks today and you will have more money to invest in stocks when prices are lower and the long-term value proposition is again outstanding. Ignoring the realities does not make them go away. Taking effective action before the price drop is the best means available to you to protect your hopes of attaining your retirement goals at the time you hope to attain them.
A head-in-the-sand investing strategy is a fear-based investing strategy. Those seeking financial freedom early in life need to work up the courage to follow a realistic investing strategy.
Objection #8 to Following a Realistic Investing Strategy — It’s Anti-Stock to Think that Valuations Affect Long-Term Returns
This is the most tragic of all the objections raised to the idea of following a common-sense investing strategy.
Stock prices are largely predictable in the long-term. That’s a good thing for stock investors. If stock prices were not at least somewhat predictable in the long-term, stock investing would be pure gambling. Stocks are my favorite asset class. But I would not want to be invested in stocks at all if I thought that long-term prices were not to a large extent predictable.
We all should be grateful that we now have the statistical tools available to us to form realistic expectations of how stocks will perform in the long term starting from various starting-point valuation levels. We all should be studying the historical stock-return data to learn what it says and to develop sensible investing strategies. We all should as a consequence be lowering our stock allocations from where we set them at times of reasonable prices.
The days of having to take wild risks as the price of participating in the stock market are over. That’s a good thing. The fact that some have come to see it as a bad thing reveals to us just how emotional an endeavor stock investing can become at times of wildly out-of-control prices.
Objection #9 to Following a Realistic Investing Strategy — The Future Might be Different than the Past
It’s true that the future might be different than the past. There are always surprises. Sensible investors should take that reality into consideration in the formation of their investing strategies.
Still, the chances are good that stocks will perform in the future at least somewhat as they always have in the past. Counting on stocks performing in totally new ways is a long-odds bet.
Objection #10 to Following a Realistic Investing Strategy — Prices Have Been High for a Long Time and Yet Stocks Have Not Done All That Bad
The valuation-informed investor has had available to him safe investment classes providing an annualized real return of 3.5 percent or better since January 1998. The returns provided by those investment classes have beat the return provided by an investment in the S&P index for close to ten years running, and at far less risk. Stocks have not been performing as we were told they are “supposed to” by those who argue for ignoring valuations for a long time now.
The historical data indicates that the story for those overinvested in stocks is likely to get worse before it gets better. No one can effectively predict the short-term. The economic realities control the long-term. The economic realities say that we are likely to see something in the neighborhood of a 40 percent real drop in the purchasing power of our stock investments (this figure includes the effect of dividends earned during the time of the price drop) in the not-too-distant future. It could be more or it could be less.
The fact that stocks performed exceedingly well during the 1990s offers little comfort to the investor seeking to follow a realistic investing strategy. The money used to finance the excess returns of the 1990s did not fall from the sky. Those returns were paid for by the stock investors of the future. The future is now. Today’s stock investors are being paid too little for the risk they have taken on because yesterday’s stock investors were paid too much for the risk they took on.
Prices go to unrealistic and unsustainable levels in wild bull markets. Common-sense investors ignore that junk. We invest in stocks, yes. But we aim to follow a realistic investing strategy when doing so. We lower our stock allocations when prices get out of hand. That’s one of the reasons why we are able to achieve financial freedom so much earlier in life than most others.