Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns changed our understanding of how stock investing works in a fundamental way. It has taken a long time for most of us to get our heads around the far-reaching implications of this amazing research.
Not all stocks gains are a positive.
Shiller’s research shows that. But how many of us believe it today? Not very many.
If valuations affect long-term returns, then the official stock price is not necessarily the real price. If there is irrational exuberance present in the stock price, then it is partly pretend. The pretend portion of the stock price will disappear in time. That’s why the valuation level affects the long-term return. Prices always move in the direction of real value over time. So. if stocks are wildly overpriced, you can count on the long-term return being lower than the usual long-term return.
This means that the best price for stocks for investors is the fair-value price, the price associated with a CAPE value of 17. Any price gains that push the CAPE above 17 are temporary gains. Investors cannot count on them for financial planning purposes. They would be better if those false gains did not exist. The investor has to dish out more cash to purchase stocks for so long as the false gains remain in place but they do not benefit him financially because they always disappear in time.
They would be better if those false gains did not exist!
It’s a remarkable statement.
Some stock gains are a negative
For as long as there has been a stock market, investors have been rooting for price gains. But we now live at a time when there is peer-reviewed research showing that some price gains are actually a negative. I have struggled for years to understand why more investors have not incorporated Shiller’s research findings into their stock investment strategies. I have come to believe that one big reason is that they lead to some highly counter-intuitive understandings of how stock investing works for those who became familiar with stock investing in pre-Shiller days. Some stock gains are a negative! Really?
Really.
Some stock gains are a negative.
In trying to accept such counter-intuitive conclusions, I think it helps to focus on the title that Shiller chose for his book. The book was titled Irrational Exuberance. That doesn’t sound good, does it? Shiller showed that at times investors do not make the choices that would advance their self-interest. They deliberately diminish the value of their portfolio. It causes your brain to hurt to think about it.
Once you recognize that we do things to make ourselves poorer than we need to be, does it not make some sense that the gains that we produce at those times bring on negative rather than positive consequences? In a rational world, stock gains would always be a positive. But it is not an entirely rational world that we live in. For so long as it is humans buying the stocks, there will be irrational purchase decisions. And, for so long as there are irrational purchase decisions, there will be price gains that bring on negative rather than positive consequences.
Price gains that reflect the economic realities are of course always positive. The problem with irrational exuberance gains is that they are not rooted in economic realities. They are the product of investor emotion, nothing more. So they lack staying power. The secret to effective long-term stock investing is learning how to distinguish the economic-based gains from the phony stuff, the irrational exuberance stuff.
It’s not a difficult intellectual task. Real gains are those that bring the stock price up to the fair-value CAPE value of 17. When the CAPE value is 34, as it is today, only half of the officially stated value of a portfolio is real. A portfolio that is said to be worth $100,000 possesses a true and lasting value of only $50,000, according to Shiller’s research.
Coming to emotional acceptance of that reality is the hard part. Most investors don’t want to hear it. And, because most investors don’t want to hear it, most investment experts don’t want to tell it. So we continue to live in a world of delusion. In which some stock gains are positive and some are not.
Some stock gains are a negative! Believe it or not, that’s what the research shows.
Rob’s bio is here.
