Or, why the best investing strategy isn’t the best for you
I love value investing. I really do. I’ve read books by Robert Shiller, David Dreiman, Benjamin Graham, and Warren Buffett (well, his letters, anyway), and I’ve come away with the sense that these guys, more than anyone else, know how to buy and sell companies. Value investors try to find strong companies, but wait to buy until their shares are cheap. Who wouldn’t agree with that as a solid investment strategy? In my mind, that’s way better than trying to find the next up-and-comer before they’ve proven they can make a dime, as some growth investors do.
But despite that, personally, I’m a buy-and-hold investor. Sometimes, I look at the market and just know it’s overpriced. But I still buy. Sometimes, I look at the market and know it’s cheap, but I buy the same amount. It’s a little paradox in my behavior, but over the years, it’s something I’ve grown more and more comfortable with. Because even though I understand the basics of how Warren Buffett does what he does, I know that I would be bad at it. Here’s why.
1. Valuing the market is not an exact science.
The absolute best valuation metric I have seen takes the price of the S&P 500 and divides it by an average of the last ten years of earnings. It’s a method that was popularized by Robert Shiller in his book Irrational Exuberance. The data on Shiller’s website goes back to the late 1800s and has been surprisingly consistent in predicting future market returns. But even a source of info as authoritative and robust as Shiller doesn’t allay my concerns. “Why?” you ask.
Well, what if we used the first few years of a human’s life to predict his future? When John was born, he weighed 8 pounds and was about 20 inches long. Now, at age five, John weighs 42 pounds and is 40 inches tall. Extrapolating his growth rate, at age 50, John will weigh 306 pounds and be 15 feet tall. See any problems here?
Put simply, the U.S. is a teenager. And save a few recessions and a depression, our growth trajectory has been steep. In the last 200 years, the U.S. went from insignificant start-up nation to hegemonic superpower. It only gets to do that once. And investing with the expectation that that kind of growth rate will continue indefinitely is pretty naive.
If the U.S. starts growing like a grown-up (i.e. not much and not rapidly), it’s hard to say what kind of effect that could have on market valuation. Investors could require a lower P/E ratio on stocks to make it “worth it” to them to invest. Maybe the real money in stocks would come from dividends instead of share price growth. Who knows?
2. The market can stay irrational for a long time.
And although the market’s average price-to-earnings ratio is about 15, it can spend long amounts of time really, really far away from that figure. It stayed below 13 between 1913 and 1927, reaching a low of 4.78 in 1920. It sunk to the single digits again in the 1930s, 1940s, and 1970s. Sure, I can see myself saying, “The market is cheap!” and buying as much as I could for a few years, but could I stick it out for fourteen years without questioning my methodology?
Or how about when the market is overpriced? The market’s price-to-earnings ratio stayed above 17 every month between May 1990 and the end of 2008. That means stocks were too expensive for nearly two decades, and I shouldn’t have bought a single stock. The 1960s and 1970s saw similar lengthy periods of overvaluation.
I couldn’t trust myself to stick to my strategy. The market’s long periods of irrationality would break me down the same way the Borg broke down nearly every race it encountered. I’d fall back. I’d resist. But eventually, the market would assimilate me. It’d only be a matter of time before I became one of the brainless many.
3. You only have to be irrational once to mess up.
Imagine the consequences of adopting a value strategy and changing your mind after a decade of seemingly contrary evidence wore down your resolve. You might have ended up loading up on stocks in the late 1990s. Or maybe you gave up on stocks in the early 1980s. Even if you did things the “right” way for years and years. That one mistake could have cut your wealth in half.
That’s the rub. Value strategies might work in the long-run, but they aren’t likely to work on your personal timeline. You’ll start needing your retirement savings when you hit age 66 (or whatever retirement date), no matter how irrational the market is in that particular year. So you’ll probably make decisions on buying and selling based on your own needs, despite market signals.
And that’s why I advocate buy-and-hold, even though I also believe value investing and the Shiller P/E are as close to “sure things” as there are in the market. Whereas value investing needs you to be on top of your game throughout your investing lifetime, buy-and-hold and asset allocation give you “mediocre” returns in exchange for the probability of not completely decimating your portfolio with a few bad decisions. Sure, you’ll hurt in times like the financial crisis. But you won’t hurt as much as if you half-assedly followed a smart strategy.