Suppose I asked you to predict the weather tomorrow. Then I asked you to forecast the weather a year from now. Which prediction is more likely to be wrong (i.e., the riskier prediction)? The stock market is just the same: The longer the time horizon, the more chance you take that something in the future will come along and blow a big hole in your investments.
In 2012, Lubos Pastor of the University of Chicago Booth School of Business and Robert Stambaugh of the Wharton School at the University of Pennsylvania won the first Whitebox prize—awarded to outstanding financial research—for their paper on the volatility of stocks. After studying over 200 years of stock-market data, the professors found the longer an investor holds on to stocks, the more that volatility (and risk) increases. Over one year, stocks showed 17 percent annual volatility; over 30 years, 21 percent; and over 50 years, 23 percent. In an interview with Cheryl Casone of Fox Business News, Lubos said, “Investors looking into the future don't only buy the historical estimates, but also buy the uncertainty associated with those estimates, and the uncertainty compounds with time.”
Pastor also noted the good fortune we boomers had during our prime investing years, saying, “The average historical return in the 20th century includes good luck, and it's not clear we'll have the same productivity growth in the future.”
Wharton professor Jeremy Siegel also considered long-term historical data when researching his classic investing book, Stocks for the Long Run. In his book, Siegel examined the financial market data from 1802 on, and argued that his research showed that investors who held onto stocks—even through volatile periods—did better in the long run. Investors ate up his advice, and his book, often called the “Buy-Hold Bible” helped convince a generation of investors to stay in the market through thick and thin. As you can imagine, I have a few things to say about this.
When did Siegel publish his first edition of Stocks for the Long Run? In 1994, during that beautifully long market rise we talked about in Chapter 7. To be fair, Siegel has published updated editions since then, but it was his 1994 book that became the blueprint for many buy-holders. And why not? As we've discussed, buy-hold worked during that unusually long period of prosperity.
Siegel did his analysis based on historical data, and acknowledged that no one can predict the future. “Economics is not an exact science, and human behavior can never be forecast with precision,” he said in the preface to his book. “Scientists can predict the paths of celestial objects flawlessly for the next thousand years, but no one has consistently been able to foretell what will happen to the market just one day, not to say one hour, in the future. But it is just this unpredictability which makes the market so fascinating and challenging.”
Unpredictability may be fascinating and challenging for a clinician, but as a financial advisor I am fascinated and challenged by the opportunity to minimize or mitigate that unpredictability so I can help my clients achieve peace of mind. Having a sell strategy can do just that, because investors know they have a certain point where they will get out of the market.
As we all know, market unpredictability can make investing risky. In terms of risk, Siegel found that other investment strategies carry less risk than buy-hold. He noted that an investor following the 200-day moving average strategy (which we discuss in Chapter 19) would have avoided the Great Crash of 1929 and the crash of 1987. So why does he prefer buy-hold over the moving-average approach? Because he believes that investors who use the moving average strategy to avoid those crashes would miss out on some of the gains that resulted from the market bouncing back.
To me, missing out on a few gains seems better than riding a bear market all the way to the bottom. The difference in the amount of money an investor could make is so marginal that I think most of us would give it up in order to avoid losing massive amounts. And remember, the goal of a sell strategy is to get the highest rate of return with the least amount of risk possible. Siegel's data shows that we would get 79 percent of the gains (net of transaction costs) while only being in the market 63.6 percent of the time. To quote Jeremy Siegel: “This means that on annual risk-adjusted basis, the return on the 200-day moving average strategy is still impressive, even when transaction costs are included.” I'll take that any day.
Siegel may be the king of buy-hold, but it sounds like he agrees with me in a number of ways: The future is unknown, the market is unpredictable, and if you want to protect your principal, buy-hold may not be your best strategy.
Like me, Robert Shiller, 2013 winner of the Nobel Memorial Prize in Economic Science, doesn't seem to be a fan of buy-hold. In his now-classic book, Irrational Exuberance (a term Alan Greenspan used to describe the market in 1996), Shiller predicted the collapse of the tech stock bubble. Like Siegel, Shiller's timing was great: His book came out in 2000, right before the Dow peaked, then spectacularly crashed. Though Shiller did write in order to sound the alarm bell about the tech-market bubble, he said that in the end his book was really about “the behavior of all speculative markets, about human vulnerability to error, and about the instabilities of the capitalist system.”
Because of these behaviors and instabilities, Shiller thinks that investors need to be more aware of risks. “We have already seen that stock price declines have not been that transitory,” he wrote, “that they can persist for decades, and thus that long-term investors should see risk in stock market investments.” In other words, stock prices can go down for a long time, and investors need to be aware of the risk they take if they decide to buy-hold.
Shiller believes that market risk and the subsequent need to protect assets are too often discounted, especially by the media. In a section where he suggests that the public should be helped to hedge risks, Shiller writes, “The personal investment media typically feature the opinions of celebrity sources who are apparently already rich and who subtly suggest that their advice might make one rich, too. It would be inconsistent with this fantasy to start talking about the mundane task of defending the value of the assets one already has. Those in the media and the investments community do not want to risk disturbing the get-rich fantasy, which they have learned to exploit to their own advantage.” I think Shiller is correct in his assertion that the media has no vested interest in spending time talking about protecting against losses. The conversation doesn't feed into the get-rich fantasy they're selling.
Maybe it was this get-rich fantasy which kept most people from listening to Shiller about the tech bubble until it was too late: “Most of what I remember is people cheerfully and with apparent interest listening to my talk and then blithely telling me that they did not particularly believe me,” he writes in the preface to the 2005 edition of Irrational Exuberance. “Some kind of collective conclusion had been reached about the stock market—and it had a powerful hold on people's minds.” Later, after the stock market boom abruptly ended, this hold turned destructive. “I remember having breakfast with a woman and her husband at the very end of 2000, when the market was down substantially from its peak, the tech stocks down more than 50 percent. She said she did the investing for the family, and in the 1990s she had been a genius. He agreed. Now she confided, her self-esteem had collapsed. Her perception of the market was all an illusion, a dream she said. Her husband did not disagree.”
But though people suffered during the recent bear markets, Shiller believes they are still overconfident. From the preface to his second edition (2005): “I do not know the future and I can't accurately predict the ups and downs of the markets. But I do know that, despite a significant slip in confidence since 2000, people still place too much confidence in the market and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes.”
People think the stock market was created to make them money. It wasn't. It was created to help businesses raise money. If businesses don't grow, or if the economy stalls during a recession, the value of investments declines. Everyone who invests in the market should understand that the market goes down as well as up, and that protecting against the inevitable drop is just prudent.
I want you to know what the top economists think so as to give you some perspective. I think these are smart guys with fascinating ideas. I think their ideas make for interesting conversation that the media loves. And I think their theories are not relevant to the average investor. As they readily admit, all of their studies still don't allow them to foretell what the market is going to do tomorrow.
I think many experts are misguided, too. I recently debated a fellow guest on the Fox Business TV show Cavuto. He argued that everything is sunny, there are no problems, and the current market has nothing but upside. When I said I believed we're building up a huge government infusion bubble with all the debt run up around the world, he countered with, “But valuations are not that high right now, so we shouldn't worry.”
I also heard Laszlo Birinyi, a market analyst I highly respect, say that we're not in a bubble because valuations are cheap, historically speaking. But how does he know they're inexpensive? As compared to what?
In October of 2002, after the tech bubble had burst, the market had gone down 49 percent from the highs in March of 2000. The market lost half of its value and, at the bottom, on October 9, a number of analysts and experts said the valuation of the market was 25.
The market then rose by 89 percent over the next five years, until December 31, 2007.
What did these same analysts estimate the valuations to be that month? 15! The valuations were lower before the big crash in December of 2007 than they were at the bottom of the market in 2002 after it had fallen 50 percent. How can it possibly be? This is ridiculous to me. The market goes up 89 percent and valuations are lower than they were before the rise?
And remember what was happening during the time of those 2007 valuations? Banks and mortgage companies were making loans and writing mortgages. They made tons of money, and their valuations were not particularly high because everyone anticipated their profits would continue to grow. But those profits were based on an illusion. Once that was exposed, the profits disappeared and the valuations became ridiculously high. A lot of the banks and mortgage companies went out of business. Others saw their stock drop by 90 percent.
I don't listen to economists. I don't listen to analysts. After millions of dollars spent on computer systems and thousands of hours of study, even these very smart people cannot foretell the future. No one knows which direction the market will go. If you had listened to those experts who defended valuations in 2007, you'd have stayed in the market and lost money.
Who do I listen to? The market. It tells us when it's going up or going down. When we told our clients to get out of the market in November 2007, we weren't paying attention to economic theories. We didn't base our move on valuations. Our decision was driven purely by the direction of the market. The trend had turned in the wrong direction, so we sold.
I don't think you have to keep up on the latest economic theory in order to protect your investments. The market has a way of confounding even the most savvy of prognosticators and computer systems, which is why I don't believe you should use them to guide you.
I think you need to look at the direction of the economy and the direction of the market. I think you need to stop listening to bad buy-hold advice. I think if you want to retire without worrying about running out of money, you need a buy, hold, and SELL strategy.