How We Ruined Our Economy – And How We Can Rebuild It

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Have you ever wondered why it is that you take price into consideration when buying everything you buy in this Consumer Wonderland of ours except stocks? You can thank (or blame!) Fama for that one.

If Fama were right, it would not be possible for stocks ever to be dramatically overpriced. That’s why you’re often told that there is no need to lower your stock allocation even when valuation levels are insane. Under the Buy-and-Hold Model, insane levels of overvaluation are impossible. So the experts don’t know what to tell you to do when they show up!

It turns out that Fama is wrong. Yale Professor Robert Shiller tested Fama’s hypothesis in 1981 and learned that, no, the market really is not automatically efficient, insane overvaluation really is possible, and investors really do need to be sure to lower their stock allocations when prices go nuts if they want to enjoy any hope of long-term success.

Oops!

For complicated reasons (which we will explore in future columns), The Stock-Selling Industry elected to keep this all hushed up for the past 30 years. The result is that all price discipline was removed from the market. No one thought price mattered much. So no one bothered to tell you that it was imperative that you lower your stock allocation during the years when it was very important both to you personally and to the economy as a whole that you do so.

A market in which no one is paying attention to price is a car without brakes. By 2000, we had overpriced stocks to the tune of $12 trillion.

Overvaluation always goes “poof!” over the course of about 10 years, and, as that amount of spending power left our economy, many businesses have felt the strain and been forced to let millions of workers go. Voila! Economic Crisis Supreme!

We are not doomed

Shiller’s findings are revolutionary. The Shiller model (Valuation-Informed Indexing) shows us how to invest in a way that permits us all to earn far higher returns while taking on far less risk. When we learn what works, we will feel less panicky about our financial futures. The animal spirits that drive the free market economy will be set free again.

The reality is that we may end up someday looking back at this economic crisis as the best thing that ever happened to us. Many of us were not open to hearing the message for as long as Buy-and-Hold had not done too much damage, but now that we appear to be headed into the Second Great Depression, more and more people each day are opening their ears to talk of new investing ideas.

That’s what we need! We need new ideas, better ideas, more enriching ideas, more life-affirming ideas!

I hope to be able to put some forward at this column. I have learned a lot about how stock investing really works over the past eight years because of smart and generous people like you who have taken time out of their days to share their thinking and thereby helped us all to Learn Together. I hope to do more of that here.

I need your help to make it work. Don’t let me down! We have an economy to save!

Rob Bennett is a new staff writer at OutOfYourRut.com and the creator of The Stock-Return Predictor. Rob is also the owner and creator of A Rich Life, a blog that aims to put the “personal” back into “personal finance”. Rob developed the Passion Saving approach to money management as well as the Valuation-Informed Indexing investing strategy, both of which are described on his blog.

( Photo courtesy of Katrina.Tuliao )

Article courtesy of Kevin Mercadante with OutOfYourRut.com