Buy-And-Hold Doesn’t Hurt Us Only During Price Crashes

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buy and hold vs market timing

The most dramatic damage done by the promotion of Buy-and-Hold stock investment strategies is experienced during price crashes. Buy-and-Holders urge investors to practice price indifference (no market timing now!).

So stock prices drift higher and higher and the amount of irrational exuberance reflected on our portfolio statements grows larger and larger until the weight of all that irrational exuberance causes the entire market to collapse and the lives of millions to be diminished.

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It’s not only in price crashes that price indifference harms us all, however.

The purpose of all markets is to set prices properly. Markets send signals. If a seller of goods or services sets his prices too high, the market sends him a signal that that inflated price is not going to fly.

If a buyer of goods or services aims to make a purchase at too low a price, the market sends him a signal that he is not going to be able to see his desire to obtain that good or service fulfilled unless he becomes more realistic re his expectations of what he should have to pay to obtain it.

Markets are truth-tellers. They push both sellers and buyers in the direction of reasonable behavior, helping both to enjoy a greater measure of happiness in this life.

Buy-And-Hold Stock Investing Strategies

The relentless promotion of price indiferent/Buy-and-Hold stock investing strategies undermines the stock market’s efforts to work that magic trick. In ordinary circumstances, stock investors would lower their stock allocation in response to price increases because price increases pull the likely long-term return on stocks down and thereby make the asset class less appealing.

But most of today’s investors are reluctant to respond rationally to price increases because they have been told that market timing doesn’t work. So prices cannot correct. Eventually, they do. Eventually, they must. But stock prices can remain at crazy levels for remarkably long periods of time so long as supposed experts are reassuring investors that there is no need to engage in market timing.

The result is that the stock market gets prices wrong for long periods of time. All kinds of negative consequences result from that.

The people running the underlying companies are misled as to whether their efforts to create wealth have been successful or not. If the stock price were remaining stable or heading in a downward direction, the executives of a company might feel a need to reconsider decisions they have made.

But when irrational exuberance brings on unjustified price increases, the natural human response on the part of those executives is to conclude that they must be doing something right. We all suffer when the executives of thousands of corporate enterprises are misled in this way. We need our stock market to set prices properly.

Effective Financial Planning

Investors are also misled, of course. Most investors are planning to use the amount in their stock portfolio to finance an old-age retirement. If irrational exuberance causes a stock portfolio to temporarily be priced at two or three times its real economic value, it becomes impossible for the investors to engage in effective financial planning.

Many investors will elect to spend a good portion of the phony gains on grounds that they are ahead of where they need to be to meet their retirement goals. Of course those investors are placed in difficult circumstances when the irrational exuberance gains suddenly disappear in a price crash.

Price-indifferent investment strategies even confound out efforts to assess the performance of our political leaders. A president who enters office at a time when the CAPE value is at rock-bottom lows has the wind at his back in his efforts to persuade voters that his economic program makes sense.

When stock prices are at super-low lows, the only direction in which they can move is up. Rising stock prices can generate trillions of dollars of wealth. Voters can hardly be blamed for attributing the increased wealth to the economic policies initiated by the political leader when in reality they were all but inevitable given how low stock prices were when he entered office.

Of course, the opposite applies when a policymaker enters office at a time of high stock prices. In that case, the politician is likely to be blamed for trillions of dollars in lost wealth as stock prices return to more reasonable levels.

When a market sets a price, it is sending a signal. The signals that markets send are often very important for all sorts of reasons. Those signals tell us all how to take effective action to make our lives better.

A stock market in which investors fail to engage in market timing senses false signals that confuse and mislead millions. It’s a terrible shame that the idea that price discipline is not required of stock investors ever became so popular.

Rob’s bio is here.