I’ve been letting lots of people know about my article reporting on The Silencing of Academic Researcher Wade Pfau by The Buy-and-Hold Mafia.
Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail sent by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:
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Rob:
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My comment on the following:
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“Which would you say were riskier in the early 1980s, stocks or CDs? I would say that CDs were far riskier. Inflation could have wiped out your returns. Stocks are virtually risk-free when they are selling at the prices that applied at that time. The likelihood was that valuations would rise dramatically over the next 10 years and the investor would obtain a return of something in the neighborhood of 15 percent real per year. In a worst case scenario, valuations would remain at insanely low levels and the return would be “only” 6.5 percent real. The only risk that I can see is the risk that the economy could have collapsed. But, if that happened, CDs would not pay off either. So the risk of stocks was certainly less than the risk of CDs at that time.”
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First of all, we know about this only a-posteriori.
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Second, about year 1980, you probably forget that at that time the short and long interest rates were sky-rocketing. You could get about 10% annual completely risk-free return from CDs. In 1982 the yield on 10-year government bonds approached 15% annual. This was much more than one could get from risky stocks, the prices of which had been decreasing from about 1966. No wonder that the PE10 dropped to about 7 at that time: investors sold stocks and bought bonds instead. And note that it was completely rational!
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Third, when you talk about stock risk, you’d better mention that you are talking about long-run risk, not short-run. If you bought stocks in 1980 and held them till 1982, you would lose. Of course, if you bought stocks and held them for about 10-20 years, you would greatly multiply your initial investment.
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I see that you focus mainly on stocks and forget about secular trends in bonds. Bonds, as stocks, also have secular bull and bear markets, and stock returns depend on whether it is a secular bull or a secular bear market in bonds. How much to allocate to bonds also depends on the current secular trend in the bond market.
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Valeri
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I replied:
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Valeri:
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On point after point, the same basic dynamic applies. If you ASSUME investor rationality, Buy-and-Hold and all the conventional investing wisdom makes perfect sense. If you ASSUME that investor emotions are the dominant influence on stock prices, Buy-and-Hold is the most dangerous strategy ever concocted by the human mind. It is the fundamental assumption that determines where your logic leads. Experts in this field spend all of their time debating the end points of their analyses. They need to examine the fundamentals. That’s where the action is (in my view!).
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Did you ever look at how the people posting at liberal web sites respond to political developments in contrast to how people posting at conservative web sites respond to them? You would think these two groups of people were living in different worlds or seeing different fact patterns play out. They view the world from fundamentally different perspectives. Both sets of people are entirely sincere. It is the starting-point world view that determines what they see when they look at the world. So it is with Buy-and-Holders and Valuation-Informed Indexers.
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You say “we know about this only a-posteriori.” That’s a Buy-and-Hold mindset speaking, Valeri (I mean no offense, please understand that I have the greatest respect in the world for all of my many Buy-and-Hold friends). You find it hard to accept that long-term stock returns are highly predictable and that investors could be so irrational as not to take advantage of this reality. So, when stocks perform in highly predictable ways, you look for reasons why investors did not act as they “should” have. The reason is that investors are not rational! They want to be. They could be a lot more rational than they are today. But to become more rational, they need more experts encouraging them to learn about what the last 30 years of academic research shows and to take advantage of tools that help them make practical use of this research and all this sort of thing. Investors cannot learn about these findings in the absence of hearing about them. We need to tell people about them and we need to encourage people to talk the findings over. Then investors will gradually become more capable of rational choices, to everyone’s benefit.
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All of the key things we “know” today about how stock investing works, we “knew” in the early 1980s. We now have 140 years of historical data available to us . In 1982, we had only 110 years of historical data available to us. But the message was precisely the same. Shiller didn’t publish his research showing that valuations affect long-term returns in 2011. He published it in 1981. The research and the data said the same thing then that it says now. It said that long-term timing is absolutely required, that any investor who fails to engage in long-term timing has zero chance of seeing his investing strategy work out well in the long term. Why? Because practicing long-term timing is nothing more or less than exercising price discipline and no market participant can do well without exercising price discipline. That’s Lesson #1. Nor can any market work if the majority of participants in it fail to exercise price discipline. Price discipline is the thing that makes markets work. Take price discipline out of the equation and you have a dysfunctional market and the price crashes and the economic crises that follow from that.
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I very much disagree that 10 percent returns were available risk-free from CDs in the early 1980s. Do you know of any peer-reviewed academic research that tells us how to predict long-term CD returns? I do not. So you are always taking on inflation risk when investing in CDs. This is not so with stocks. The U.S. economy has for 140 years been sufficiently productive to support returns of 6.5 percent PLUS inflation and, at times of insanely low prices, the return naturally goes up to 15 percent real. It is not possible to obtain similar returns from CDs on a risk-free basis. Stocks offered a far better long-term value proposition than CDs in the early 1980s, according to the academic research (in my assessment!).
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You say “no wonder that the P/E10 dropped to about 7 at that time,” suggesting that the reason was the price drops we were seeing from 1965 forward. You are ignoring the effect of the relentless promotion of Buy-and-Hold strategies by the “experts” in this field! Say that Shiller has published his research in 1971 instead of 1981 and that we all had been promoting Valuation-Informed Indexing all along. In that case, investors would have responded to the lower stock prices in the same way they respond to lower prices for any other good or service they buy in this consumer wonderland of ours. They would have gotten excited about the lower prices and increased their darned stock allocations! That would have brought those insanely low stock prices back up to reasonable levels in no time flat. It is the relentless promotion of Get Rich Quick/Buy-and-Hold strategies that causes insane price levels like that (and all the human misery that goes with the unemployment rates we see at times when we permit the heavy promotion of such doomed strategies). Had we all been telling people all along what we learned from Shiller’s research, none of this would have posed any problem whatsoever.
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I of course disagree that it was “completely rational” for millions of investors to sell their stocks at a time when the most likely 10-year annualized return was 15 percent real. I see it just the other way around. I see it as rational for investors to increases their stock allocations when the long-term value proposition is outstanding and to decrease them when the long-term value proposition for stocks is worse than it is for no-risk asset classes.
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You are 100 percent correct that I am talking about long-term strategies, not short-term strategies. Shiller’s research confirms the Buy-and-Hold finding that short-term timing never works. I view that insight as the second most powerful investing insight in history. None of what I am talking about works in the short term. In fact, in the short term, Valuation-Informed Indexing is often a total disaster (look at what happened from 1996 through 1999 for a recent, real-life illustration of the point). This stuff does not work in the short term. That point cannot be emphasized enough. I believe that much of the confusion re these points is that investors have a natural but unfortunate inclination to focus on the short term and there is so much money to be made in this field by appealing to this unfortunate inclination that most “experts” in the field feel pressured to rationalize the promotion of strategies that are precisely the opposite of the strategies they would recommend if they used the last 30 years of peer-reviewed academic research as their guide.
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You say that an investor who bought stocks in 1982 and then held for 10 to 20 years would do very well. This is so. But is it because the investor followed a Buy-and-Hold strategy or is it because stocks were priced to deliver outstanding long-term returns in 1982? I say that it is the latter. Buy-and-Hold can APPEAR to work for a time. But it only works when stocks are priced to deliver a strong long-term value proposition. Buy-and-Holders don’t sell when the long-term value proposition turns bad. So they eventually give up most of the gains they enjoyed in earlier years. It is because Valuation-Informed Indexers don’t do this that they are able to retire so many years earlier. The Valuation-Informed Indexers go with the same high stock allocations as the Buy-and-Holders during the years when stocks offer a strong long-term value proposition. But they lower their stock allocations when the long-term value proposition for stocks is no longer there. So they never experience the portfolio wipeouts that are eventually experienced by EVERY Buy-and-Holder (there has never yet been an investor who followed a Buy-and-Hold strategy for an investing lifetime and did not see most of the accumulated gains of a lifetime wiped out at one point — this has never once happened to any Valuation-Informed Indexer). The only difference between the two strategies is that the Valuation-Informed Indexers retain a far higher percentage of their gains and thus feel a far greater emotional peace about the investing experience than the Buy-and-Holders, who pretend for a time that their bull market gains are real and then suffer great emotional angst as the phony gains disappear into thin air in the secular bear brought on by the relentless promotion of Buy-and-Hold strategies.
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Finally, I would not be inclined to set my bond allocation by “the current secular trend in the bond market.” I would compare the long-term value proposition available from bonds with the long-term value proposition available from other asset classes and go with the asset class offering the better deal. My view is that all investors should be seeking the asset classes that offer the best returns at the lowest risk. If all investors did this, the investing markets would work as well as other markets, in which market participants do precisely this. It is this idea that investors should follow entirely different sets of rules that cause all the trouble. Investors need to be informed about what works to be able to invest effectively and investors need to invest effectively for our markets to stabilize and remain healthy.
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It all makes sense — But only from the perspective of someone who has rejected the conventional idea that investors can invest rationally without taking price into consideration when making purchase decisions. If you ASSUME that rationality is possible without price discipline, you will end up in a very different place. My question to you is — Is that because the other place is the right place or is it because your starting-point ASSUMPTION could never permit you to arrive at any other destination?
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Please do not take any of this personally. I like you and I respect you just as I like and respect all of my many Buy-and-Hold friends. I interpret your questioning as a sincere desire to figure out where I am coming from and so I am trying my best to be as frank as possible while also being as polite and warm and respectful as is obviously appropriate. I hope you will hear these words in the spirit in which I am sending them your way, my new friend.
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Rob
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