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

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 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

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 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

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

“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

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

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