I often describe the Buy-and-Hold stock investment strategy as “a Get Rich Quick scheme.” This surprises people. The general view is that Buy-and-Hold is the opposite of that. The idea is to tune out the noise about whether stock prices are headed up or down in the short term and instead focus on the reality that the short-term ups and downs always cancel each other out and stocks always provide great returns in the long run. Buy-and-Hold investing is calm, responsible investing. There is nothing Get Rich Quick about it.
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I think there is because of one very important reality of the stock investing experience on which few investors are focused. Stock prices are set by investors. We have the power. We can set stock prices wherever we please. That changes everything.
A Strong Incentive To Push Stock Prices Up
We think of the money in our portfolio as funds that we can use to finance our retirement. So we have a strong incentive to push stock prices up as high as we can. And there is almost no limit to how high we can push them. If we are all worried about whether we will have enough to retire (and pretty much all of us are), we could push stock prices up to two times fair value and thereby solve the problem. If that didn’t quite do it, we could push them to three times fair value. There is no referee who can call “Foul!” when we create new money for ourselves in that way.
This cannot be. There must be some limit on the extent to which we can do this.
The Buy-and-Holders certainly believe that there is. Buy-and-Hold was developed at a time when there was a widespread academic belief in the Efficient Market Theory. This theory posits that changes in stock prices are determined by economic developments. If stock prices were set improperly, investors would exploit the errors by entering transactions permitting them to profit from them until the errors were corrected. Since investors possess a strong incentive to act in their self interest, all investors can count on the market to get prices right or at least as close to right as it is possible to get given the information about the economic realities that is publicly available.
If the Efficient Market Theory checked out, Buy-and-Hold would indeed be the ideal strategy. The precepts of the strategy follow from the premise on which they were constructed.
The Market Is Not Efficient
There’s a problem, however. Nobel-prize-winning Economist Robert Shiller showed in research published in 1981 that the market is NOT efficient. If the market were efficient, prices would play out in the form of a random walk (hence the title of the book that did more than any other to popularize the strategy, A Random Walk Down Wall Street). Eugene Fama, another Nobel-prize-winning economist, showed that prices played out in the form of a random walk over the course of six month or a year or two years. But Shiller showed that stock prices are highly correlated to valuation levels over 10-year and 20-year time-periods.
That can’t be. Not if the market is efficient. How can we explain the long-term correlation between stock prices and valuation levels? Shiller suggests that investors are NOT rational, that they possess a desire to bid stock prices as high as they can and that they act on that desire even though their common sense tells them that a decision by millions of investors to do so cannot end well.
That desire to push stock prices up beyond the levels where they would reside if only economic realities were considered is the Get Rich Quick urge that lives within all of us to get something for nothing. We don’t like to admit that we possess this emotional weakness. But Shiller’s research shows that we do. We are surely better off admitting it and dealing with it than ignoring it.
The Buy-and-Holders do not admit it or deal with it. In the mind of the Buy-and-Holders, it’s as if Shiller’s research didn’t exist. They continue to invest themselves and to encourage others to invest as if the market were efficient, as if investors were rational and as if the numbers on their portfolio statements reflected solid economic realities.
Practice Market Timing
What should they do? They should encourage investors to practice market timing, to own more stocks when prices are low and long-term returns are high and less stocks at times when prices are high and long-term returns are low. Stock prices would become self-regulating in a world in which most investors faithfully practiced market timing.
That’s not the world we live in. The Buy-and-Holders disdain market timing and Buy-and-Hold is the dominant model for understanding how stock investing works. There is today no brake on our emotional desire to push stock prices up, up, and up some more. The Buy-and-Holders are price indifferent, they believe that stocks are a good buy at any price.
Another way of saying it is that the Buy-and-Holders believe that it is fine if we all let our Get Rich Quick urge run rampant when buying stocks.
Rob’s bio is here.
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