Robert Shiller author of Irrational Exuberance and a well respected Yale

Robert shiller author of irrational exuberance and a

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Robert Shiller, author of Irrational Exuberance and a well-respected Yale professor of economics, contends, as I do, that emotion often determines the prices in the market, resulting in prices that are often far lower or higher than values. The graph he created looks like an abstract of someone’s nightmare, but actually it shows what happens if you buy when the market has a low price-to-earnings ratio (PE) versus a high PE ratio. Dr. Shiller’s graph shows that low PE ratios (left side of the graph) coincide with high returns (the top of the graph) and that high PE ratios (right side of the graph) coincide with low returns (bottom of the graph). Note that the bottom-right portion of the graph shows investors who bought at a 20–30 PE ratio got a −2 percent to 5 percent return for twenty years. Price is what you pay. Value is what you get. Don’t let anyone tell you that you can’t get a 0 percent return for twenty years by buying and holding the S&P 500 index. If you buy when the index has a high PE ratio, it’s not only possible to get a bad return for twenty years, it’s likely. (The original graph has much more information on it as Dr. Shiller created it—with colored dots. To see the original color graph, go to . Or see another black-and-white version in his wonderful book Irrational Exuberance .)
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The PE is a ratio of price to earnings (price per share divided by earnings per share). Sometimes the PE is referred to as the “multiple,” because it shows how much investors are willing to pay for each dollar of earnings. If a company has a PE of 10, that means an investor is willing to pay $10 for every $1 of earnings. On the other hand, if you buy and hold when the S&P 500 index PE ratio is low, your chances of a good return are excellent. From 1970 to 1985 there were several years when the PE on the S&P 500 hit below 8. Those years mostly yielded a twenty-year return of 10 percent or better. Dr. Shiller’s research teaches us something incredibly important: If you intend to buy and hold for long periods of time, you’d better do your buying when prices are low . You buy when there’s a lot of fear. You sell when there’s a lot of greed.
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This explains quite a lot of the pain that mutual fund investors are feeling now. They bought mutual funds in the 1990s and early 2000s, when the S&P 500 PE ratios were soaring. Now they’re seeing the market going nowhere and their compounded returns dropping toward zero. They’re praying for the market to go back up, and it will … eventually. But Dr. Shiller’s research suggests that people who bought into the market in the 1990s are in for a twenty-year average return that will be hovering around zero. Meanwhile, this is great news for a savvy stockpiler. If you can get a twenty-year 12 percent return from just buying the entire S&P 500 index at the right time (versus a twenty-year 0 percent return for buying at the wrong time), can you imagine the return you might get if you stockpile the best and most on-sale businesses, rather than just buying all of them?
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  • Spring '20
  • Warren Buffett

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