Drip Guy made a good point in a post he put to the Goon Central board a few weeks ago. Ataloss argued that the reason why I say that the Old School safe-withdrawal-rate (SWR) studies are analytically invalid is that I don’t approve of relying on historical stock-return data to determine the SWR. Drip Guy quite properly responded that: “He wants to enlist ‘historical data’ to his own cause, so the inference is not that looking at history is innately bad in Hocoworld, but instead that prior studies were somehow specifically in error.”
To appreciate the significance of my claim that the Old School studies are in error, it is helpful to understand the history behind development of the Old School studies.
Middle-class investors have long been anxious about investing in stocks. People have noticed that stock prices sometimes go down dramatically. Since most people hate the idea of losing large portions of their life savings, this observation quite naturally led to a widespread skepticism re the idea of investing too heavily in stocks. That was the state of play prior to the rise in popularity of the Passive Investing concept, an approach to understanding how stock investing works that is the root cause of the analytical errors in the Old School studies.
Passive Investing is irrational. It is obviously not smart to stick with a stock allocation adopted at a time of reasonable prices at a time when prices have risen to dangerously overpriced levels. So, in ordinary circumstances, no reasonable person would be advocating Passive Investing.
The reality is that many otherwise reasonable people recommend Passive Investing. It has become over the past three decades the dominant model of understanding how stock investing works. Huh? How dat happen?
What happened is that some very good ideas got mixed in with some very bad ideas. We have developed tools for analyzing the historical stock-return data that have permitted us to make stock investing a far more rational business than it had ever been in the years before these tools came to be available to us. Unfortunately, being the humans that we are, we messed up the implementation of these tools. Because of the mess-up, we ended up making stock investing a less rational business than it has even been rather than a more rational business than it has ever been. Oops!
If you have read the book Stocks for the Long Run, you know how the “rational” approach works. The idea is to look at the historical data, identify certain patterns, and assume (quite reasonably, in my view) that stocks are likely to perform in the future at least somewhat as they have always performed in the past. Following this procedure, you can make reasonable forecasts of how the stocks you buy are likely to perform.
This is a big deal. If you know how stocks are going to perform, you no longer need to be anxious about price drops. Sure, you might experience some doozies. But so what? If the claim put forward in Stocks for the Long Run — that stocks are always the best asset class in the long run — is right, price drops don’t matter so much. Price drops are temporary. Just stick with stocks, and all will be okay in the end. Don’t worry, be happy.
Most of the maxims that you have heard about stock investing over the past 20 to 30 years are the product of this “rationalizing” of the stock investing project. It is because of what they believe the historical data says that the “experts” say that no form of timing (even long-term timing) can work. It is because of what they believe the historical data says that the “experts” say that the conventional approach to buy-and-hold (sticking with a high stock allocation even when prices go so high that this becomes an extremely dangerous thing to do) is the way to go. It is because of what they believe the historical data says that the “experts” say that taking on more risk always leads to obtaining greater returns.
Wrong! Wrong! Wrong!
Passive Investing enthusiasts argue that their approach is the only rational one because their approach is rooted in the historical data. What the historical data says is not a matter of subjective opinion. It is a matter of objective fact. When you base your investing decisions on what the historical data says, you are basing your investing decisions on something solid. Passive Investing enthusiasts are not entirely wrong to claim that their approach is the only rational one; it really is more rational to focus on objective sources of information rather than subjective ones.
They are indeed wrong to say that their approach is the only rational one or even one of the rational ones, however. They are right in their rationale for making the claim. The historical data really is an objective source of information, and that really is important; objective information bits really should generally be given greater credibility than subjective information bits in investing analysis. There’s one big problem with these claims of the superiority of the Passive Investing approach, however. The analyses that back up this approach (including the research presented in Stocks for the Long Run) do not include adjustments for the effect of changes in valuations. The valuations factor is the single most important influence on long-term stock returns. Leave out that factor, and your claims to rationality break down. Leave out that factor, and all of the numbers you generate with your “research” are wrong!
The Passive Investing enthusiasts persuaded middle-class investors that it is safe to invest heavily in stocks even at times of sky-high prices. They did this because of what they saw in research that ignored the effect of valuations. Research that considers the critical valuations factor generates completely contrary findings. It is not safe to invest heavily in stocks at times of sky-high prices. It is extremely risky. Stocks are not the best asset class at times of sky-high prices. They are the worst. Hoo boy!
It is confusion over this point that is at the core of the “controversy” we have seen over the Retire Early Community’s SWR findings of recent years. The Old School studies, rooted in the Passive Investing model, say that the SWR is always 4 percent; the long-term value proposition of stocks is stable under this model. The New School studies say that the SWR ranges from 2 percent to 9 percent; the long-term value proposition of stocks depends heavily on the valuation level that applies at the day of a stock purchase, according to an analytically valid examination of the historical data.
I’m right. They’re wrong.
The Goons say it just the other way, of course. Listen to the Goons tell the story, and you will hear claims that they are right and I am wrong. That’s what makes them Goons!
I’m joking, of course. What makes them Goons is that they rely on deception, intimidation and word games to make their case. I think it would be fair to say after six years that they have no choice. I have never yet seen anyone try to make a non-Goon case for Passive Investing. The Goons have been driven to abusive posting (it is not my intent to excuse them but only to point out a partial explanation of their behavior and of our tolerance for it) by their discovery of the core irrationality of their investing beliefs. They very, very, very much do not want to change their beliefs and they have discovered that there is no rational defense of their beliefs possible.
The point of this blog entry is that Drip Guy is right in what he says in the words above. I do not find fault with those who use the historical data to assess the long-term value proposition of stocks. I love that idea! When I discovered Greaney’s web site, one of the things I most loved about it was his focus on SWRs. I get bored very quickly with hearing one expert say one thing and then another say another thing and then another say yet something else. All the blah, blah, blah leaves you knowing no more than you knew before you tuned in. The historical data tells you something solid, something you can sink your teeth into. One point re which I have always thought that Greaney nailed it was his insistence that we should rely on the historical data for guidance on when we have enough assets to be able to retire safely.
Where Greaney goes off the rails is in his claim that those who take valuations into account are “mentally ill.” I don’t buy it. Smart investors have been taking valuations into account since the day the first stock market opened for business. Warren Buffett is arguably the smartest investor who ever lived and his entire approach is rooted in performing valuation assessments.
If you love the idea of Rational Investing (I do!) but you hate the idea of failing to take valuations into account (I do again!), you cannot buy into the Passive Investing model. Yes, this model became extremely popular during the most out-of-control bull market in the history of the United States. But what chance does an approach rooted in research that gets all the numbers wrong have of surviving the most out-of-control bear market in the history of the United States (the historical data shows that bull markets are financed by a borrowing from future returns, so the largest bull markets set the stage for the largest bear markets)? Truly rational investors care about getting the numbers right. Truly rational investors do not invest passively, but in a valuation-informed way.
The historical data flipped!
That’s what happened. During the years when our visions of Getting Rich Quick through bull markets that went on forever dulled our ability to think clearly about the need to include all critical factors in our analyses of what the historical data says re long-term stock investing, we came to believe some things about stocks that cannot possibly be so. Now that prices are beginning to move a bit in the direction of fair-value price levels, our illusions are unraveling. The lesson is not that Rational Investing is a bad idea. The lesson is that Rational Investing needs to be truly rational. If you are going to use the historical data to guide your investing decisions, you need to be sure to use an analytically valid methodology to examine it.
Greaney and I are soul brothers on the question of the value of learning how to invest successfully by studying the historical stock-return data (I don’t get the sense that there are too many community members other than John and I and John Walter Russell who feel so strongly about this question). We are sworn enemies on the question of whether it is necessary to take valuations into consideration when performing an historical analysis. Greaney says that it is evidence of “mental illness” to do so. I say that it is not possible to get the numbers even remotely right without taking into account this critically important factor.
The historical data itself is objective. But those subjective humans have made it a matter of opinion as to whether all the factors that affect the question being examined need to be included in an analysis of what the historical data says on a given research topic. I like to think that there is one point re which we are all in complete agreement — those humans will do it to you every time!
Today’s Passion: Jeremy Siegel is a Dangerous Individual. I say it, so it must be so!