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

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

I don’t get very well the concept here, so I believe people may disagree with it.

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

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

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

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

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

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

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

I’m going to run that post as a Guest Blog Entry on Tuesday, Arty. More people need to see those words.

Rob

Thanks, John.

Rob

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

“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

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,

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

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