Shadox at the Money and Such blog recently posted a blog entry entitled Passive Investing Is for Extremists: The Critque.
Juicy Excerpt: His main claim relates no so much to how you invest in stocks, but rather to the percentage of your portfolio that is invested in this asset class, regardless of which stocks or stock funds you put your money into. I think that it is more correct to say that Rob is against passive asset allocation, than he is against passive investing as I understand it.
Shadox became my favorite personal finance blogger with the posting of his skeptical but fair and balanced critique.
Juicy Excerpt: I’ve been writing about these issues on the internet on a daily basis for seven years now. It has been a rare event in that time for me to see someone coming at these questions from the other side to respond to my presentation of them in a manner as intelligent and balanced as yours. I am not a flatterer. I say that in all sincerity. I am very impressed.
This guy is the real turtle soup and not the mock. He’s into Learning Experiences.
Rob,
I believe that a 100% stock allocation will do very well at Year 30 if you never make deposits or withdrawals.
Its results are comparable to shifting allocations according to valuations.
As soon as you introduce an allocation to bonds, the story changes.
As soon as you make withdrawals, the story changes.
Have fun.
John Walter Russell
Its results are comparable to shifting allocations according to valuations.
I tried running four tests with the Strategy Tester.
For each of the four scenarios, I used a $100,000 portfolio value, a 2.5 percent TIPS return, no additions or withdrawals and a 14 starting-point P/E10 value.
For Scenario One, I went with 100 percent stocks.
For Scenario Two, I went with 100 percent stocks up to a P/E10 of 12, then 80 percent stocks up to a P/E10 of 19, then 50 percent up to 21, then 20 percent.
For Scenario Three, I went with 100 percent stocks up to a P/E10 of 24, then 0 stocks.
For Scenario Four, I went with 100 percent stocks up to a P/E10 of 20, then 0 stocks.
At 30 years, Scenarios One and Two did about the same. Scenarios Three and Four did a good bit better. Scenario Four did the best.
The best result went from 1.1 million in Scenario One to 1.4 million in Scenario Four.
The mid-point result went from $600,000 in Scenario One to $700,000 in Scenario Four.
My tentative take is that being heavily in stocks offers such a benefit that going with a 100 percent rebalancing strategy is able at the end of 30 years to match a Valuation-Informed Indexing strategy that generally calls for a stock allocation of less than 100 percent. You are countering the harm done by not considering valuations by going with a higher stock allocation.
However, taking valuations into account gives better long-term results if you are willing to go with a VII strategy that also calls for going with a 100 percent stock allocation much of the time.
Again, this was a quickly done test. What I say here is tentative and the question being examined should be studied more closely by lots of smart people.
Rob
Rob,
Another point: Valuation informed indexing typically guarantees a higher minimum outcome.
A 100% stock allocation has a very wide range of outcomes. When it does well, it does very well. When it does poorly, it does a horrible job.
This will be an interesting challenge.
Have fun.
John Walter Russell
A 100% stock allocation has a very wide range of outcomes. When it does well, it does very well.
Jeremy Siegel argued in “Stocks for the Long Run” that some might want to consider going with a stock allocation in excess of 100 percent (borrowing to buy stocks). Most view that advice as reckless. I think a theoretical case can be made for it at times of low valuations. I personally would never borrow to buy stocks. But I think there is a case that can be made that in some circumstances and for some people it is an idea worth considering.
I certainly don’t see it as being any more dangerous to borrow to buy stocks at a time of low valuations than it would be to go with a high stock at a time of insanely overpriced stocks. Lots of big names advocated that from 1996 to 2008. Siegel’s idea is viewed as reckless, but in relative terms his idea (so long as it is not taken too far) is the prudent one (in my view).
Rob
I don’t get very well the concept here, so I believe people may disagree with it.
Rob,
Remember that “Stocks for the Long Run” came out when valuations were sky high.
Put P/E10=26 Bear Market into the Strategy Tester. Just about everything in the way of Valuation Informed Indexing looks better than 100% stocks.
Still, with its high volatility, 100% stocks occasionally does very well.
At today’s valuations, 100% stocks can do well if you have enough time and an iron stomach.
Have fun.
John Walter Russell
I believe people may disagree with it.
I suppose that just about anything is possible in this crazy old mixed-up world of ours.
Thanks for joining in the discussion, doc. I hope we hear from you again.
Rob
Remember that “Stocks for the Long Run” came out when valuations were sky high.
Yes, The advice was put forward at a time when it was terrible advice.
Still, I think Siegel made an interesting point. If people really believed what they were saying about stocks at the time, they should have been willing to borrow to buy stocks.
My take is that Siegel’s point was a legitimate one in some circumstances and not in others. I acknowledge that I myself could not pull the trigger on a decision to borrow to buy stocks, even at a time of low valuations. I find Siegel’s point interesting from a theoretical point of view.
Rob
Rob,
I think that the Stock Returns Predictor can tell most of the story.
Waiting 30 years will work well enough if you can stand what happens in the meantime.
Have fun.
John Walter Russell
Waiting 30 years will work well enough if you can stand what happens in the meantime.
I agree in a theoretical sense. But I also believe that investing “experts” need to put more focus on real-world considerations.
It’s hard for me to imagine that more than a tiny percentage of the population has ever been able to stick with a Passive strategy for 30 years, given the financial devastation that has always followed in the past from adopting a Passive strategy.
Does anyone know if there has ever been a real live investor who employed Passive for the long term and was able to stick with this strategy for 30 years? It would be interesting to know if there is someone who has actually done this in the real world.
Rob
Hey, Rob,
Just back from a long trip to Europe. Hope you and yours are well. Was playing with your strategy tester. Nice tool. Some questions on it:
1. Are you assuming that the non-stock portion is always invested in TIPS at the rate you indicate? And is that why you require an entry rate for TIPS?
2. What is the difference between PE 14 Bear Market vice Normal Market? What are the a priori assumptions you plugged into the model that differentiates them?
Thanks,
Arty
Hi, Arty. It’s always nice to hear from you.
Yes, the calculator uses the TIPS return you enter to calculate a return for the portion of your portfolio not in stocks. You don’t need to invest in TIPS to use the calculator. You could use the return you expect to get from CDs or a money market or bonds or whatever. But you need to enter some number so that the calculator knows what return to assign to the money not in stocks.
I cannot give you details about the formula used to distinguish a P/E10 of 14 in a Normal market from a P/E10 of 14 in a Bear Market. You would need to ask John Walter Russell (he’s at http://www.Early-Retirement-Planning-Insights.com).
The goal was to replicate how stocks have always performed in the past in those two different sorts of markets. There’s a difference between being at 14 in the sort of market we are in today (where investors are extremely emotional in their thinking re stocks because we have just lived through the most out-of-control bull in history) and the sort of market we will be in when we are at 14 on the way back from the price crash we are likely to see sometime within the next few years.
Stocks in the past have always gone to valuation levels far lower than those we are at today in the wake of out-of-control bulls. That doesn’t mean that that will certainly happen this time. If you play with the calculator, you will see that it does not always happen with the calculator either. But the odds of that happening today are higher than what they would be if we were not today living in the wake of an out-of-control bull. The calculator was designed to reflect that reality.
Rob
The goal was to replicate how stocks have always performed in the past in those two different sorts of markets. There’s a difference between being at 14 in the sort of market we are in today (where investors are extremely emotional in their thinking re stocks because we have just lived through the most out-of-control bull in history) and the sort of market we will be in when we are at 14 on the way back from the price crash we are likely to see sometime within the next few years.
—
I see. Just curious what he is “telling the machine” to differentiate between teh two. Maybe you could lure him here for a description if a simple one is possible at all. I use the PE 14 because it is closest to where we are at today based on the options given but was unsure which one I should use (I assumed BEAR market, yes?).
You believe we are headed for yet another crash even at these “fair values” you mention in your podcasts?
—-
Arty
I’ll put up a note re this discussion at the most recent blog entry. John often checks the comments. So that might bring him here.
What he’s “telling the machine” to do in a conceptual sense is to replicate what has happened in the historical record. The tough part is deciding what sort of distinctions to make. The record shows that stocks perform differently at times like today than they do at times of a “normal” P/E10 of 14. So we included that distinction. But it is fair to say that there are some judgment calls involved in deciding what sorts of distinctions to make note of and which sorts of distinctions to let be buried in the mix.
“14 Bear” is the right calculator choice for today’s conditions.
Yes, the odds are that we will see one more huge stock crash before we are out of the woods. We’ve been at insane price levels four times in U.S. history. On the earlier three occasions, we ultimately went to price levels one-half of those that apply today. So all investors should be prepared for a 50 percent drop from where we are today sometime over the next five years or so.
Three tests is not enough to say anything for certain. So I don’t think it’s a good idea to avoid stocks entirely today just because we are likely to see another crash. What if we don’t? You want to be covered for that possibility.
And, even if we experience another big crash, you will likely end up with a good return at the end of 10 years. This was not true for those investing in stock before the 2008 crash. So the risk today is much less than it was pre-crash. The money people lost in 2008 was lost for good (it never existed in the first place — it was cotton-candy nothingness). The money people will lose in the next crash is a temporary loss only; it will be made up in the following years.
And it’s possible that the crash will not take place for some time. Each year that you are out of stocks you pay a price for being out of the best long-term asset class. You need to take that reality into consideration when setting your allocation.
The key consideration today is the investor’s emotional outlook. I recommend that Passive Investors go to a low stock allocation until they come to a better understanding of the ABCs of stock investing. Passives have suffered too big a hit to expect to be able to stick with stocks through another big crash. Rationals haven’t experienced much of a hit. I think it makes sense for Rationals to go with a moderate stock allocation at today’s prices. Today’s price levels are good. Stock today offer a strong LONG-TERM value proposition despite the likelihood of another price crash.
Rob
even at these “fair values” you mention in your podcasts?
If investing were an entirely rational endeavor, there would be no reason to expect a price crash from fair-value price levels. Please understand that investing is a HIGHLY emotional life endeavor.
Investors are today struggling to understand why they have lost much of their life savings even though so many of the “experts” told them with such certainty that this was impossible. We are all in the process of taking in the information that the Passive Investing model, which was marketed as being data-based, was in reality rooted purely in emotion (the data was added only as a rationalization of emotion-based claims).
It takes time for that process to be completed. When it is, people will likely be distrustful of stocks for some time to come. That distrust will result in stock prices far below fair value, in the event that stocks perform in the future anything at all as they always have in the past.
Rob
Rob said:
“The key consideration today is the investor’s emotional outlook.”
John Walter Russell said:
“Waiting 30 years will work well enough if you can stand what happens in the meantime.”
John also said:
“Another point: Valuation informed indexing typically guarantees a higher minimum outcome.”
Rob said,in July 9th, 2009 at 2:30 pm
“It’s hard for me to imagine that more than a tiny percentage of the population has ever been able to stick with a Passive strategy for 30 years, given the financial devastation that has always followed in the past from adopting a Passive strategy.”
——-
Rob,
these are all important comments. John’s comments suggest to me the aim of avoiding big losses in down years.
I infer from Rob’s comment (whether he intends so or not) what I see as most important consideration to successful (long-term) investing: commitment to a “strategy.”
The opposite of commitment is selling-out, (usually low and usually at the time of low market valuations but high *perceived* risk, like last November). The issue for me, is that a good strategy has to be one in which you have conviction. The biggest threat to conviction, in my observation, is sustaining big losses. And I think most investors are indeed risk-averse, regardless of the silly little test they take in initial consults with an advisor when designing a portfolio strategy.
So, a successful strategy—whatever it is—has to be one that reduces the far left fat tail—dampens the big loss. Absent that, most investors are going to be tested—likely to their limit. Recognizing this changes the relative experience of *living with* a particular strategy even as two strategies may produce similar returns.
After playing with your calculator, I did some detailed observations using specific asset classes (funds that many individuals could have invested in). Here’s a specific example (using specific stocks and bonds) that embraces several valuation periods:
Portfolio 1 (1972-2008)
Cost adjusted Gross Return: 9.39%
Best year (among other similar): 1975 38.7%
Biggest losing years:
2008: -37.04%
2002 -20.96%
2001: -10.97%
Portfolio 2 (1972-2008)
Cost adjusted Gross Return: 9.6%
Best Year (by far): 1985 22.8%
Biggest losing years:
2008: -7.59%
1973: -1.19%
1974 -0.67%
(small gains in 2001 and 2002)
Similar returns between the two strategies over the same long time period. Now, which strategy would you rather have lived through? Which strategy would an investor have been likely to adhere to?
Keep in mind John’s point:
“Waiting 30 years will work well enough if you can stand what happens in the meantime.”
Arty
Another way of saying it is that emotional extremes beget emotional extreme.
If we permitted honest posting on the realities of stock investing, market prices would be self-regulating. When prices got too high, we would be able to warn people of the dangers and people would naturally sell. That would bring prices back to reasonable levels.
What we did during the Passive Investing Era was to only allow people to hear wildly slanted reports of what the historical data tells us about stock investing. Many people believed those reports and have suffered devastating losses as a result. Those people will become strongly disillusioned with stock investing as the reality hits re how their life opportunities have been damaged through promotion of this investing “strategy.” The disillusionment will likely bring prices not to fair value, but to something far below fair value.
We all should be working to open the internet up to honest posting. When honest posting is permitted, people can learn the realities. Investors who understand the realities of stock investing are far less likely to get caught up in the emotional extremes.
In a world in which honest posting re stock investing is permitted, you would not see the sort of economic crisis that we are living through today because we would not have millions of middle-class people suffering such devastating life setbacks and needing to cut back on spending so dramatically. It is the spending cutbacks forced on us through the promotion of Passive Investing that are the primary cause of the economic crisis.
All these things are connected. The key problem is the “idea” that stocks are the one asset class on Planet Earth re which the price at which you buy them makes no difference. When that idea gets popular, we always see a huge economic crisis. There is not one exception in the historical record.
Rob
a successful strategy—whatever it is—has to be one that reduces the far left fat tail—dampens the big loss.
This says it EXTREMELY well. 90 percent of investing analyses should be aimed at helping investors do this, in my assessment. This is pretty much the entire ballgame.
Your example of the two funds is FANTASTIC. You want to be in the fund that you are realistically able to remain invested in for the long run. That’ the one that works for investors not just in theory but in the real world.
Rob
Rob said,in July 10th, 2009 at 6:16 pm
“Your example of the two funds is FANTASTIC. You want to be in the fund that you are realistically able to remain invested in for the long run. That’ the one that works for investors not just in theory but in the real world.”
Rob
—
Rob,
Yes. I think our discussion locates the crux of the matter, and it is indeed found at the emotional. But is has taken me some added work to understand the real threats, vice the lesser order issues that tend to dominate most discussions.
A successful, long-term investor must have a belief system and be committed to a strategy that avoids the great risk of “bailing-out” (which includes either performance chasing or outright going to cash).
Now, here is where it gets interesting, because there are very different ways to accomplish this, but to me, they usually share the common feature of Fat Tail reduction (an often used Larry Swedroe term, actually). And it might be accomplished with a valuations-based strategy, as you have endeavored to discover, which, not surprisingly, requires low beta exposure—but at high valuation periods and not necessarily throughout.
The two examples I provided, above, were buy and hold portfolios across a 37-year period using funds that many investors could access.
The first portfolio was obviously a TSM fund—100% stocks! Clearly, if you held that portfolio your returns were nice, but you were tested—and I wonder how many could have held it 37 years.
The second portfolio, while returning about the same, did not compete in bulls, but hardly suffered much in bears, even last year, and not at all in ’01-’02. It was a strategy whereby the equities were “Tilted” to small value and emerging markets (risky asset classes) but dampened by 70% Short-term Treasuries, thus accomplishing a low beta exposure and fat tail reduction. It is unlikely this investor was severly tested in any downturn. That is good.
Low beta being the key to reducing the big losses, and, in my view, staying committed for that long.
The portfolio below (#3) also reduces fat tail risk, uses TSM as its sole stock allocation and adds 2 low-correlating asset classes to it (Gold and LT Treasuries), and has a similar return to the other two portfolios, while being *very* different:
Portfolio 3 (1972-2008)
Cost adjusted Gross Return: 9.79%
Best Year (by far, the rest much lower): 1979 42.1%
Biggest losing years:
1981: -3.9%
1994 -2.5%
(small gain in 2008!)
This is the Permanent Portfolio and someone using a buy and hold strategy with it would have earned those returns across 37 years.
I’m not recommending any of these portfolios/strategies just making an observation on why they work.
So buy and hold can work over the a long term, and stay protected in the short term, and return well over time. But there is a catch.
The portfolios that I presented (#2 and #3) carry a risk—not surprisingly, an emotional one—that is their greatest threat; it is called “tracking error regret”. That means, they may perform very differently than “the market”. That means in bull markets, these portfolios will still make some money but be outperformed, badly, by traditional portfolios. (But, recall, these are the same traditional portfolios that then get crushed in the bears!)
But, the smart investor who respects the greatest threat of all, “bailing-out” in a big downturn, *must* be willing to trade-off not doing well as his friends in bull markets. He must be willing to make much less in boom cycles to lose far less in bust cycles. That is how one can actually “stay the course” with a single allocation. But the tradeoffs must be fully understood.
A valuations-based strategy also carries this risk. For if you were worried in 1993 at P/E 20, you may have reduced too much and missed 7 great years, making far less than your friends. Here too, tracking error regret is the emotional threat that must be understood to profit.
As evidenced by famous “Plan B” options, even veteran investors don’t know this, probably because they were advised, outright or subtly, to hold more beta exposure than they should (for all sorts of reasons like fear of inflation or blatant optimism or whatever). And they did not envision just how tough the tests were or how easy it would be to quit. But it takes education on the matters that truly *matter most*, and then belief in one’s implementation of that education.
Arty
the smart investor who respects the greatest threat of all, “bailing-out” in a big downturn, *must* be willing to trade-off not doing well as his friends in bull markets. He must be willing to make much less in boom cycles to lose far less in bust cycles. That is how one can actually “stay the course” with a single allocation. But the tradeoffs must be fully understood. A valuations-based strategy also carries this risk.
I agree entirely, Arty.
These are deep truths.
What you are saying is not intellectually hard to understand, in my assessment. But it does not “click” with many today because it’s rooted in a different mode of thought than what is encouraged by the Passive model.
The Passive model was essentially a first draft effort at long-term investing. The first draft was terribly flawed and we need to move on. The problem today is that there are too many who are emotionally invested in the first draft.
The issues to which you are pointing are the most important strategic investing issues of the future, in my view.
Rob
I’m going to run that post as a Guest Blog Entry on Tuesday, Arty. More people need to see those words.
Rob
Rob,
A quick comment: I used Ed Easterling’s definition of long lasting (secular) Bull and Bear Markets to generate Stock Return Predictor equations for Bull and Bear Markets as well as the standard Normal Market. The Bull and Normal Market predictions are very close. The Bear Market predictions differ enough to treated separately.
People can visit his site http://www.crestmontresearch.com or read his book “Unexpected Returns” to see the dates.
I have documented my equations at my site.
Have fun.
John Walter Russell
Thanks, John.
Rob
Rob,
Thanks. I invented none of this. All I did was look at different sources, try to establish a common underlying concept, and synthesize what I learned from others.
In fact, it was a combination of your valuations work (taking Shiller’s work and “running” with it), and Larry Swedroe’s untypical but powerful observations on manipulating the potential dispersion of returns (Fat Tail trimming) that enabled me to appreciate this with my current conviction. When very different approaches accomplish the same thing, one needs to see why.
All the other asset allocation minutiae stuff that gets so much attention in the media or on boards is secondary at best, and at it’s typical worst, a distraction from the true fundamentals. That has to change.
And, of course, the whole implementation thing rests on the behavioral. One must have conviction in the models that actually work, and then fortitude to perservere with them, otherwise, one is better off staying out of equities altogether. I suspect, that either conviction or avoidance occurs usually after one has been “blooded” by a bear, so to speak. A lucky few “get it” absent such direct contact!
John’s calculator is very cool and enables a fast visual of how dispersion of returns can be shaped, even using only TSM (or do you use the S&P 500 for equities, which is almost the same?). I get what your saying about the same PE ratios being different in bear markets and normal markets.
John’s statement “Valuation informed indexing typically guarantees a higher minimum outcome,” points indirectly to the fat tail reduction issue—but *however* it is achieved. It accomplishes this by giving up the better possible returns in trade for reducing downside loss. This alone better enables investor perserverance, I think, tracking error notwithstanding.
It seems simple now. But I must confess it has taken me awhile to get it and appreciate precisely what must rest at the base of any successful (real world) strategy: conviction.
Arty
I invented none of this. All I did was look at different sources, try to establish a common underlying concept, and synthesize what I learned from others.
I feel exactly the same about the work I have done, Arty. I never “invented” anything either. I just looked at some stuff, identified some problems, tried to figure out how to fix them, and ended up where I am today.
It doesn’t matter how you got to where you are. What matters is whether you are saying something important or not and whether you are right in what you are saying or not. I believe that you are saying something important and that you are right.
When very different approaches accomplish the same thing, one needs to see why.
You’re saying that you were puzzled about something and that you tried to solve the puzzle. That’s just how I work. When I see puzzles, I don’t push them aside, I try to figure them out. Doing that can take you to some exciting places over time.
All the other asset allocation minutiae stuff that gets so much attention in the media or on boards is secondary at best, and at it’s typical worst, a distraction from the true fundamentals.
I am in total agreement. My view is that 90 percent of the work being done in the investing field today is aimed (not consciously, of course) at AVOIDING the realities instead of at discovering them. If we could get those energies directed to a constructive purpose, there is no end to the good we could do.
People are not dumb, people are smart. But today most investing “experts” are using their intelligence to “defend” Passive Investing. Once people give up on that project, there’s going to be a flood of great stuff. People have been trying for 28 years to figure out a way to discuss the realities as they have been revealed to us in the academic research of recent decades. Once we get to critical mass, watch out!
the whole implementation thing rests on the behavioral. One must have conviction in the models that actually work, and then fortitude to perservere with them, otherwise, one is better off staying out of equities altogether.
We are in complete agreement. Accepting this insight opens up an entire new world of additional insights to our exploration. Saying that it’s emotion that matter changes the history of investing in a profound way. Once there is a consensus reached on this point, no one can write or speak about investing in the old way ever again. Every article written is changed in a significant way by acceptance of this key reality. The implications reach in a hundred directions.
This of course is why some see the Rational model as a threat. That’s the supposed “downside” in the minds of some.
The full reality, however, is that even those who today feel threatened by discussion of the realities end up far better off by accepting them and exploring them. No one benefits by remaining limited by ignorance. That CANNOT be the way to go.
A lucky few “get it” absent such direct contact!
I would like to understand better why some “get it” and some do not. Having a clear take on that would obviously help in persuasion efforts.
do you use the S&P 500 for equities, which is almost the same?)
We use the S&P 500.
John’s statement “Valuation informed indexing typically guarantees a higher minimum outcome,” points indirectly to the fat tail reduction issue—but *however* it is achieved.
I certainly do not say that Valuation-Informed Indexing is the only Rational way to invest. The purpose of VII is to provide an approach to indexing that works in the real world. I believe that many middle-class investors need something simple because they do not want to spend a lot of time with investing. Passive Indexing has been heavily promoted as a good strategy for those people. We know now that Passive cannot work. So we need a Rational approach to indexing. That’s VII.
But VII is just the first and most basic Rational strategy. My hope and expectation is that scores of Rational strategies will be developed by scores of different people in days to come. VII is a sketchy first draft, no more and no less.
It accomplishes this by giving up the better possible returns in trade for reducing downside loss. This alone better enables investor perseverance
I see this as being a hugely important insight. It needs to be examined from dozens of different angles over a long period of time.
We need to TEACH people to give up on the desire to obtain the best possible short-term result. That’s what it comes to. This does not come to people naturally. Giving up the best short-term result is counter-intuitive. But it CAN be taught. And the long-term benefits of learning this lesson are enormous. Investors who are willing to give up the best short-term results can retire five years earlier than would otherwise be possible.
ALL investing experts should be engaged in this teaching effort. This is the entire deal. Those who learn how to give up the desire for short-term gains will become successful long-term investors. Those who do not will not. All of the emotion that causes trouble for stock investors has its roots in this tension between what we think we want (good short-term results) and what we really want (good long-term results).
It seems simple now. But I must confess it has taken me awhile to get it
That so for me too. We need to figure out why it is so hard for many to appreciate such a simple and important and life-enhancing idea. I think it is because the idea is so basic and so at odds with the key principles of Passive Investing. People do not hear it because they are not accustomed to hearing it. I believe that the better ideas will prevail when they are heard more often and from more people and are explored from more angles and are presented in more formats (written articles, podcasts, speeches, calculators, etc.)
Rob
Rob said:
“We need to TEACH people to give up on the desire to obtain the best possible short-term result. That’s what it comes to. This does not come to people naturally. Giving up the best short-term result is counter-intuitive.”
Rob,
Exactly this. Of course, the entire Wall Street machine, CNBC et al, work counter to this and attacks those “natural,” though undeducated, desires.
I have a friend who teaches exercise science and writes peer-reviewed papers attacking the mainstream dogma (which is just as bad in that field as this one).
He makes a point I think you’ll appreciate on differentiating science and marketing, and it addresses your investing views because you, and John, are approaching the problem more in a “scientific” manner (statistical and behavioral). Here is what he says on Day 1 to his students:
“For you to get an “A” in science (this class) means you must be willing to get an “F” in marketing.”
Arty
“For you to get an “A” in science (this class) means you must be willing to get an “F” in marketing.”
Amen. That’s the entire deal. Arty.
Investing is a path. You choose emotion (Passive) or you choose reason (Rational). And that makes all the difference. Where you start determines where you end up.
It’s true that we have a huge marketing machine against us. That is of course discouraging.
The other side of the story is that the success of Passive shows that the middle-class investor feels a deep desire for something more substantial than marketing slogans. They didn’t choose just any old marketing slogans. They chose ones that sound prudent and reasonable and long-term-oriented. Passive is a Get Rich Quick scheme but people don’t choose it because they are looking for a Get Rich Quick scheme. “Buy-and-hold” sounds prudent. They are using our natural and healthy aversion to risk to trick us (presumably not intentionally, but the effect is the same) into going with the most risky strategy imaginable.
Our hope lies in the fact that people very much WANT something better. People WANT to know what really works.
And the truth is — even The Stock-Selling Industry would be better off if people were permitted to learn what works. Bringing the entire U.S. economy to its knees does not help The Stock-Selling Industry in the long run. The promotion of Passive brings only short-term profits.
My thought is that the financial pain we will have caused ourselves with this is going to be so great before the economic crisis is over that even the most dogmatic Passives are going to throw their hands in the air and cry out “Make it stop!” Promoting Passive helps absolutely no one. It’s a lose/lose/lose/lose/lose.
The transition is hard. It’s going to take a frightening amount of pain to get us to a point where some of the Big Shots will be able to pronounce the Three Magic Words. But it is my belief that even the most puffed-up of the Big Shots will be very excited about what they discover when they get to the other side. Humans have a dark side and humans have a wonderful life-affirming side. Both things are so, in my experience.
I don’t think that the people who organized the marketing campaigns had any idea of the monster they were creating. My sense is that a lot of them are today horrified by what they have done. They just cannot figure a way out. They feel that they have painted themselves into a corner. I believe that we need to do everything we can (short of posting dishonestly) to make them feel comfortable with making the change and assured that there is a place for them in the world of investing experts after they admit their mistakes. It’s a delicate business getting from where we are to where we all very much deep in our hearts want to be, but I believe that it can be done.
In any event, we don’t have much choice but to give it a try. Another 50 percent price drop is going to put this economy in very serious trouble. We’re going to need to have someone around to pick up the pieces. My thought is that those of us who possess at least a reasonable understanding of the realities should be doing all we can to set things up so that we can make forward progress as quickly as possible once things get to a point where the Passive dogmatics are open to permitting it.
We all lose if the entire economy or perhaps even our system of government goes under. I have a hard time seeing how anyone would see that as a benefit.
The one big thing we have going for us is that Reality doesn’t care about the intimidation tactics. Reality just is, like a mountain or an ocean. An investing model that defies reality in deference to marketing considerations ultimately fails because it doesn’t work.
The long-term keeps getting closer and closer all the time, you know?
Rob
Rob,
Rob wrote:
“Please understand that investing is a HIGHLY emotional life endeavor.”
“Investing is a path. You choose emotion (Passive) or you choose reason (Rational).”
Rob,
I think you’ve provided a rational model in your work.
I also think my specific examples show that it is possible to be “passive” (or “buy-and-hold”) and also be rational—but only if the emotional component you mention is made patently clear and informs a suitable (real world) strategy—the considerations for which we have been discussing.
But this has not been done. And absent that, failure is, and has been, likely. I suspect, as you seem to, that more pain—and fear—is likely needed to focus attention.
“Fear is useful,” as Odysseus says to Achilles in the movie, “TROY.
Arty
I also think my specific examples show that it is possible to be “passive” (or “buy-and-hold”) and also be rational—but only if the emotional component you mention is made patently clear and informs a suitable (real world) strategy
I completely agree.
There was a fellow at the Financial WebRing Forum who said that someone might just want to stick with a single stock allocation because he is more emotionally comfortable with that. If that is the motivation for a passive strategy, that strategy is Rational.
The key would be — does the person recognize that he is likely going to see lower returns as a result of adopting this approach? If he does, and if he chooses the strategy all the same because of a personal preference, he is being Rational. We all have personal preferences and we all should be taking them into consideration in setting our investment strategies.
Say that someone said “I understand that the risks of investing heavily in stocks at times of high valuations are great and thus I am just going to always go with a 30 percent stock allocation.” That’s Rational. It’s not a choice that I would make. But it is a Rational choice. The person is choosing what works for him.
What makes the Passive (with a capital “P”) approach irrational is the claim that is is a good idea not to change one’s stock allocation in response to big price changes. That is flat-out insane. That fails even the common-sense test. There has never been any rational argument ever put forward in support of that one and there has of course never been any historical data put forward supporting that one. So that one must be rooted in pure emotion. Going Passive (with a capital “P”) is making a deliberate choice to invest emotionally. That choice leads to all sorts of bad things down the road.
I do NOT say that Passives are deliberately ruling out the use of reason in the development of their investment strategies. I do not believe that at all. The Passive idea was a MISTAKE. The people who promoted it really did believe in it at one time and it has been so heavily promoted that there are now millions who believe in it (many presume that anything promoted so heavily must be valid). What I say is that in an objective sense Passive is 100 percent emotional. Because of what we have learned from the academic research done from 1981 forward, we now know that valuations affect long-term returns and that Passive cannot work in the real world.
I think the thing to do is to distinguish between passive investing and Passive Investing. A passive strategy can be Rational. But the Rational Investing model is defined as the rejection of the intense emotionalism that has become characteristic of the Passive model from the late 1990s forward. The difference is that “passive investing” is a choice that some might make because of some appeal that it holds for them personally. In contrast, Passive Investing is a model that claims that there is some sort of scientific justification for believing that there is some sort of benefit to be had from not adjusting your stock allocation in response to big price swings. To argue that is to engage in deliberate acts of irrationality.
That stuff is just marketing jizz-jazz. That stuff is the enemy of the middle-class investor. It’s that stuff that has caused all the financial misery that middle-class investors have suffered for the past 10 years.
Rob
Rob,
This sort of clarity is exciting.
It helps greatly, once we embrace those a priori factors that truly make the difference—in reality. Once fully understood, and believed, the specific implementations can then be diverse.
Arty
Rob,
http://www.ritholtz.com/blog/2009/07/shiller-stocks-fairly-valued-but-could-go-down-a-lot/
Shiller would seem to support your view on the current state of affairs and present danger. Also lends credence to John’s way of dividing valuations into Normal and Bear environments.
Makes me wonder that certainly one reasonable approach (a conservative view) is to hold a small to midling allocation stocks always, but even when valuations truly favor. And then cut sharply even from there for even fair valuations.
Obviously, this is not a perfect science and guys like Shiller (and me) are conservative. And I found interesting results on the strategy testor using this approach. Again, I feel the worse crime is to get caught in an overvalued state with too much equity rather than too few equities while a bull is running. But each investor has a unique situation that modifies all this. Which is why anything generic in advice is often absurd.
Arty
this is not a perfect science
I don’t think it can ever be a perfect science.
Consider what it is that we are examining when we examine valuations. It’s human emotion. It’s human emotion that causes both overvaluation and undervaluation. If investing were a 100 percent rational endeavor, stocks would always be priced fairly. There would never be either overvaluation or undervaluation.
So what we see in stock prices is a reflection of how people feel. It’s not possible to give effective investing advice without learning about human psychology. An examination of human psychology can never be reduced to numbers. So purely numbers-based exercises can never give us all the answers.
What the numbers do is to let us know when we have let things go totally bonkers. When the numbers get really, really bad for stocks, responsible people need to sit up and take notice. To ignore valuations in that sort of situation puts the entire economy and possibly even the entire political system at risk. In those sorts of circumstances we need to care enough about our economy and our political system to speak back to those in The Stock-Selling Industry trying to shove the Passive investing marketing slogans down our throats.
Rob