There is only one reason why understanding stocks is hard for most of us. The trouble is that the people that most of us think of as “experts” are employed by firms that make money from the selling of stocks. There is a heavy pro-stock bias to the conventional wisdom in this field. This causes huge amounts of confusion for millions of investors.
The simple reality is that stocks are like anything else that can be bought or sold. They offer an amazing value proposition at some prices, a strong value proposition at other prices and a terrible value proposition at still other prices. The key to understanding stocks is understanding stock valuations. Buy stocks only when they are selling at reasonable or low prices and you will never go wrong. Buy stocks when they are selling at insanely high prices (as they have been in recent years — this article was posted in December 2011) and you will suffer a wipeout.
This article offers brief descriptions of three RobCasts that address the fundamentals that you need to comprehend to develop a sound understanding of stocks. Robcast #41 addresses the issue of valuations. Robcast #95 tackles the issue of risk tolerance. Robcast #172 describes 30 myths about stock investing that can steer you wrong if you are not put on notice of the analytical errors in which they are rooted.
Understanding Stocks / RobCast #41 — Bogle and Valuations (Please click on the title to gain free access to RobCast #41).
Robcast #41 makes the following points:
1) The stock market had mispriced stocks by $8 trillion in the days prior to the 2008 crash. That is the real reason we have all lost so much money. The economy is not to blame. The problem is that we continued investing heavily in stocks even when they were insanely overpriced.
2) It is nonsense to think it is okay to go with the same stock allocation when stocks are priced at two times fair value as you went with when they were fairly priced. Buy-and-Hold can never work for so long as stock valuations continue to shift wildly. Stocks are more dangerous when highly priced. So you need to go with a lower stock allocation at such times.
3) Buy-and-Hold advocates told us to buy stocks after the crash because they were “cheap.” But is it that stocks were cheap after the crash or that they were insanely overpriced prior to the crash? If it is the latter that is the case, the experts should have been telling us to lower our stock allocations prior to the crash. We would all of course be better off today if they had done so.
Understanding Stocks / RobCast #95 — Risk Tolerance in the Real World (Please click on the title to gain free access to RobCast #95).
RobCast #95 makes the following points:
1) The stock crash has caused many middle-class people to lose confidence in stocks. This is a terrible mistake. Stocks are wonderful. Give up on stocks and you will delay your retirement by many years. What we need to give up is our belief in the crazy idea that it is okay to stay at the same stock allocation at all times (Buy-and-Hold). We all should be going with lower stock allocations when stocks are selling at insanely high prices. There’s no other way to keep your risk profile roughly constant.
2) Money concluded after the crash that stocks are more risky than we realized. No! Stocks are a low-risk asset class for those willing to lower their stock allocations when prices reach insanely dangerous levels. It’s not stock investing that’s risky. It’s Buy-and-Hold investing strategies that make stock investing risky for many.
3) John Greaney gets the optimal stock allocation wrong because he fails to consider the effect of valuations. The reality is that there is no one optimal stock allocation. The optimal stock allocation varies with changes in stock valuations.
Understanding Stocks /RobCast #172 — 30 Investing Myths in 60 Minutes (Please click on the title to gain free access to RobCast #172).
RobCast #172 makes the following points:
1) Buy-and-Hold is not a scientific approach to investing. It once was. There was academic research supporting the strategy in the 1960s and 1970s. But Yale Economics Professor Robert Shiller published research discrediting Buy-and-Hold in 1981 and there has been no effective response by Buy-and-Holders to Shiller’s findings in the past three decades. So Buy-and-Hold is discredited science.
2) Stock price changes are not random. They are highly predictable. Long-term returns are always good starting from moderate prices and long-term returns are always poor starting from high prices. So Dollar-Cost Averaging (buying the same amount of stocks at a variety of different prices) does not make sense.
3) Investing experts are influenced by the fact that they make so much money persuading people to buy stocks at all times. Legitimate experts would tell people both when stocks are worth buying and when they are not.
For background on my development of the Valuation-Informed Indexing model for understanding stocks, please take a look at the “About” page for my A Rich Life blog.