Archives for July 23, 2008

Those six words sum it all up. That claim is what The Great Safe Withdrawal Rate Debate has been all about.

The dominant investing theory of today — the Efficient Market Theory — says that it cannot be so. This theory posits that investing is a 100 percent rational endeavor. It makes no sense for safe investments to offer higher returns than risky investments. It is irrational. It cannot be. So says today’s dominant theory, a theory that has influenced 90 percent of what you have read about what to do with your savings for the past 25 years.

The Efficient Market Theory says that it cannot be so. What does The Stock-Return Predictor (a calculator that reports how stocks will perform in the future presuming that they perform in the future anything at all as they have always performed in the past) say? The Return Predictor tells us that at the top of the bubble (the P/E10 level was 44 in early 2000) the most likely 10-year annualized return for stocks was a negative 1 percent real. TIPS were at the time paying 4 percent real with a government guarantee attached. The safest investment in the world was paying five full percentage points more of return per year than stocks, which were at the time the riskiest an investment they have even been in U.S. history.

Safe investments can offer higher returns. That’s the reality.

The reality conflicts with the theory. What to do, what to do?

The “experts” say that we need to ditch reality, cover it up. Telling people the realities might undermine their confidence in the theory we all use to tell people what to do with their money.

Huh? Whazat?

Reality trumps theory. If the theory conflicts with reality, it is the theory that is wrong — the purpose of a theory is to describe reality accurately. We don’t dump reality. We dump the theory. So says Old Farmer Hocus.

Safe investments can offer higher returns. You would think judging by the reaction we have seen that telling people that is telling them bad news. It’s not, of course. It’s wonderful news. What could be better than learning that you can get higher returns by taking on less risk? That’s what we all should be seeking to do.

To get angry upon learning how to do it is to become a slave to theory, to put the desire to hang on to a discredited theory ahead of the desire to finance our retirements. Not this boy. No way, no how. I’m here to learn how to achieve financial freedom as early in life as possible. I love theories that help, I have no use for theories that hold me back.

Safe investments can offer higher returns. They usually do not, of course. The usual rule is that safe investments offer lower returns. But there are times when things are stood on their heads. How come? How do things get so messed-up? Why isn’t stock investing rational, as the theory insists it must be?

It’s because stocks are bought and sold by humans and humans ain’t rational. Perhaps you’ve noticed.

Take the humans out of the equation and perhaps we can bring that Efficient Market Theory back for another run. For so long as humans are permitted to own stocks, though, forget it. Assuming rationality in those circumstances is going off to live in an imaginary world. That’s not the smartest thing to do when putting together an investing strategy.

Here’s the kicker.

It’s only by acknowledging that human investors are irrational that humans can invest rationally. Holy irony, Batman!

There’s a fellow named Larry Swedroe (he’s written some investing books) who I mentioned this to over on the Vanguard Diehards board. His response was that, when stocks pay a lower return than normal, they are safer than normal. Stocks were paying the lowest expected return in history back in 2000, so it follows under Swedroe logic that stocks were the safest they have even been in those days. What do you say to something like that?

I said that it sounded to me that he was repeating back to us stuff he had read in books rather than using his intelligence (it is clear that Larry possesses a good bit of intelligence) to come to a rational understanding of the realities. He said that I was being “patronizing.” Again, what do you say?

Was I being patronizing? I feel that I was showing more respect for Larry’s intelligence than Larry himself was showing for Larry’s intelligence. Larry was putting forward words that made Larry sound like a fool. I know that Larry is not a fool. I was trying to lift Larry’s thought process to a higher place.

Safe investments can offer higher returns.

If you can accept that, you can learn how to invest rationally. Figure out why it is that safe investments sometimes offer higher returns than risky investments and you are well on your way to figuring out how stock investing works in the real world.

The alternative is to become a slave to a theory that has failed us.

I like theory as much as the next guy, probably more. But I only like theories that work. When I see that a theory does not explain reality at all well, I go off looking for another theory.

How about you?

Today’s Passion: One weekend I went to visit my mother in Philadelphia and didn’t bring my computer with me. I woke up early and was looking for something to do. So I pulled out my notebook and tried to come up with some reasons for sticking with a theory after it becomes obvious that it has failed. The work product of that morning’s effort is an article entitled Woody’s Allan’s Take on the Efficient Market Theory. The short version is that we believe that safe investments cannot offer higher returns because, well — we need the eggs.