Investor Psychology and Economic Realities Are Very Different Things

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There’s only one difference between Buy-and-Hold and Valuation-Informed Indexing. Buy-and-Holders believe that stock price changes are determined by economic developments. Valuation-Informed Indexers believe the determining factor for stock price changes is shifts in investor psychology. It’s one difference but it leads to differing perspectives on just about every investment strategy question that comes up.

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Stock Prices Are Determined By Economic Realities

Say that an investor wants to know whether he has accumulated enough assets to retire. The one who believes that stock prices are determined by economic realities looks at the number at the bottom line of his portfolio statement and assesses whether that amount is enough for him to live on for his remaining years. The one who believes that stock prices are determined by investor psychology makes an adjustment for the CAPE value that applies at that time. If the CAPE value is at two times the fair-value CAPE value, as it is today, he divides the number on the portfolio statement by two. That leads to a very different conclusion as to whether or not he has accumulated enough assets to retire.

Say that an investor is concerned about the sorts of sharp price drops that we saw near the end of 2008 and during the early weeks of the Coronavirus crisis this year. The one who believes that stock prices are determined by economic realities presumes that the problem is economic in nature. If government authorities can fix the economic problem, stock prices will recover and his portfolio will be fine. The one who believes that stock prices are determined by shifts in investor psychology places the blame for the sharp price drop not on economic factors but on high stock prices (that is, high levels of investor emotion).

He understands that prices always fall hard once investor emotion gets too out of hand. So he does not see the answer to the problem in economic reforms. He sees the answer as educating investors not to price stocks too high. We never see big, lasting price drops starting from times when stocks are priced at low or moderate levels.

Say that an investor is spooked by a price drop and is trying to determine whether to stick with his stock allocation or not. The one who believes that stock prices are determined by economic realities worries that the economic factors that have pulled stock prices down are likely to remain in place and continue to pull prices down some more. The one who believes that stock prices are determined by shifts in investor psychology is encouraged by the fact that the price drop has diminished the effect that irrational exuberance has been having on stock prices. The lower stock prices go, the better the long-term value proposition offered by stocks. That investor sees falling stock prices as a signal to increase her stock allocation.

Shifts In Investor Psychology

Say that an investor reads in the morning newspaper that stock prices rose to record-breaking highs on the previous day. The one who believes that stock price changes are determined by economic realities gets excited. Rising prices means improving economic conditions, which permit us all to live better lives. The one who believes that stock price changes are determined by shifts in investor psychology has a more ambivalent reaction. He is of course happy to see the size of his portfolio increase. But he foresees stocks offering smaller returns on a going forward basis as irrational exuberance is always transformed into irrational depression in the long run. So the positives of a price increase are countered by the negatives of a price increase.

Say that an investor is nearing retirement age. The one who believes that stock prices are determined by economic realities cuts back on his stock allocation. Economic developments cannot be known in advance. He doesn’t want to take a chance that negative economic developments will cause his portfolio to be sharply diminished as he enters a stage of life at which he is no longer bringing in an income.

The one who believes that stock prices are determined by shifts in investor psychology believes that price changes are largely predictable. If valuations are high, he would reduce his stock allocation whether he were nearing retirement age or not. If valuations are low, he would not be inclined to reduce his stock allocation much even if he were nearing retirement age. He would see low prices as an opportunity to generate higher returns for a time and thereby diminish his need to take on the risks of investing in stocks in his old age.

Say that an investor noticed that super-safe asset classes like IBonds and Treasury Inflation-Protected Bonds (TIPS) were offering amazing returns (both of those asset classes were offering returns of 4 percent real in early 2000). The one who believes that stock prices are determined by economic realities would not let that reality affect his stock allocation. It is his understanding that stocks are always the best asset class as it is risk that determines return and only stocks are sufficiently risky to offer suitable returns.

The one who believes that stock prices are determined by shifts in investor psychology would switch a portion of his portfolio from stocks to TIPS or IBonds if stocks were priced to offer returns not high enough to justify the greater risk attached to investing in them. This investor believes that stocks are generally the best investment class but also that there are times when irrational exuberance gets so out of hand that the super-safe asset classes offer a stronger long-term value proposition than that offered by stocks.

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