Bill Bernstein nails it in his new book.

The Investor’s Manifesto – Sneak Preview (PDF file).

The first paragraph of chapter 2.

If you learn nothing else from this book, it should be that risk and return are inextricably intertwined. In almost every
country where economists have studied securities returns, stocks have had higher returns than bonds. Further, if you want those high stock returns, you are going to have to pay for them by bearing risk; this is a polite way of saying that in the course of earning those higher returns, your portfolio is going to lose a truckload of money from time to time. Conversely, if you desire perfect safety, then resign yourself to low returns. It really cannot be any other way.

I say that the reason why stocks pay such a high return is because when you buy stocks you are buying a share in U.S. productivity and U.S. productivity has long been sufficiently strong to finance a 6.5 percent real average return.

When you buy corporate bonds you are buying a share in U.S. productivity and yet the return on corporate bonds has been much less that shares.

The 6.5% return is due to the price people paid for the shares not the 3% or less real growth that the US economy has experienced.

If people had paid less for shares the return would have been greater, if they had paid more the return would have been less.

People are willing to pay more for a less risky return.

If we eliminated volatility (by educating middle-class investors re the ABCs of stock investing and thereby taking the emotion out of stock prices), the return on stocks would remain the same.

No it wouldn’t.

People who now shun stocks because of the risk would be attracted by the 6.5% real return with no volatility. People with stocks and bonds would sell bonds and buy stocks. (Why settle for low returns with bonds when you can get higher returns with the same low volatility).

This flood of money would drive up prices and lower returns.

6.5% real return with no volatility would be the greatest investment of all time. The only way you fairy tale can work is if people ignore this terrific investment.

In the real world such an investment would attract such a flood of money that prices would rise and returns would fall.

The 6.5% return is due to the price people paid for the shares not the 3% or less real growth that the US economy has experienced.

We don’t agree, Evidence.

If U.S. companies did not generate enough in the way of profits to support a 6.5 percent return, the return to stockholders could not be 6.5 percent real. Where do you think the money that goes to shareholders comes from? It comes from corporate profits.

Your 3 percent number does not incorporate all the factors. My guess is that what you are leaving out here is dividends. Stockholders get the dividend PLUS the growth experienced over their time of ownership. Bogle does a great job of explaining how the various factors apply to generate a return of 6.5 percent real in his books and speeches. It is from Bogle that I learned about this aspect of things.

Rob

People are willing to pay more for a less risky return.

The entire historical record shows just the opposite, Evidence.

The most likely long-term return for stocks in January 2000 was a negative 1 percent real. The guaranteed return at the time for TIPS was 4 percent real. That’s a differential of 5 percentage points of return for 10 years running. Those going with stocks were making a deliberate choice to give up 50 percent of their initial portfolio value. Yet most investors were choosing stocks over TIPS at the time.

The idea that there is a connection between risk and return is an assumption.. An assumption is not a finding. The entire historical record shows this assumption to be false.

Does the assumption make sense? It almost does. It makes sense IF you believe that investors are 100 percent rational. The trouble is — they are not. It is humans who buy stocks. Humans are not entirely rational creatures. Assume that they are when making your calculations and you are going to get all the numbers wildly wrong. It will happen every time.

Humans are often willing to take on far more risk for the “reward” of enjoying a far lower return. We saw this for the entire time-period from 1996 through 2008. And we have seen it many other times in the historical record too.

I believe that human investors can be made more rational than they are today.To do that, we would have to educate them about the ABCs of stock investing. We would have to make tools like The Stock-Return Predictor widely available. For so long as investors are not able to learn the ABCs, stock investing is going to remain a dangerously risky business.

Stock investing risk is optional. We choose to make stock investing risky by denying people the tools they need to make rational investing decisions.

Rob

6.5% real return with no volatility would be the greatest investment of all time.

We agree.

Rob

In the real world such an investment would attract such a flood of money that prices would rise and returns would fall.

I am proposing that we permit people to have the tools they need to invest effectively, Evidence.

You are of course right that a flood of money into stocks could cause valuations to rise and long-term returns to fall. But if we permit people to have access to the tools they need to invest rationally, those who no longer see value in stocks with the lower returns will sell as a result and that will bring prices back to reasonable levels. Stock prices are self-regulating when we permit honest posting on these questions.

This is the part that you are always leaving out of your analysis. You are presuming that people will continue to invest irrationally even if we permit them access to the tools they need to learn the ABCs of stock investing. Why would they? Why would people not want to retire years sooner? What would be their motivation for continuing to invest irrationally if they had available to them the tools needed to make more effective choices?

People will be happy to invest rationally if they are permitted to learn the realities.

You cannot have a free market without free speech. We do not today have free speech on investment-related topics. We are only permitted to parrot the marketing slogans of The Stock-Selling Industry and not to point out the contradictions in them. Once we permit free speech on investment topics, the days of irrational markets are over. All investors are going to want to be able to retire years sooner and will be willing to invest rationally to make that possible.

You are assuming today’s craziness will continue in world in which investors are permitted to learn the realities. Why would it? I agree that humans are capable of irrationality. But I say that they are also capable of rationality. Both things are so. Permit people to have access to the information they need to invest rationally, and I think we are going to see a big change.

Rob

But if we permit people to have access to the tools they need to invest rationally, those who no longer see value in stocks with the lower returns will sell as a result and that will bring prices back to reasonable levels.

The reasonable level for a volatile asset is different than the reasonable level for a non volatile asset. If you did manage to remove volatility then the reasonable level for stocks would rise.

You continue to employ the assumption that the return on stocks is set by some market process (that investors are being compensated for taking on risk). I dispute this. I say that the return on stocks is set by the profit-generating potential of the underlying companies.

An example.

Company A makes certain profit each year.

Year 1 $1000
Year 2 $1010
Year 3 $1036
Year 4 $1026
Year 5 $1038

Assuming all profits go to the owners then the owners make $5110. Easy so far.

What percentage return did the owners make on their money ?

Can you answer that question Rob or is there a piece of information that I have left out?

Can you answer that question Rob or is there a piece of information that I have left out?

You’ve left out an explanation of why you view this question as relevant to the discussion.

Rob

The answer of course is that I have left out the single most important item for determining investment return, the price paid.

There is no one alive who believes more strongly that the price paid affects the return obtained, Evidence. From one perspective, what you are saying here makes all the sense in the world.

Still, it’s a reality that stocks pay an average long-term return of 6.5. This is an objective fact.

If you pay more than fair value, you get a 10-year return of a lot less than 6.5 If you pay less than fair value, you get a 10-year return of a lot more than 6.5. So, yes the price you pay does matter. A lot.

At the end of 30 years, though, the price you pay doesn’t matter much. At the end of 30 years, it’s not valuations that affect your return but the productivity of the U.S. economy. At the end of 30 years, your return is close enough to 6.5 that the valuation level that applied at the time you made the purchase doesn’t matter than much anymore.

I don’t get the relevance of this to the questions being discussed above.

We agree that valuations matter (to the extent you really believe this — you have indicated elsewhere that you do not believe it). But the fact that valuations affect long-term returns does not rule out the possibility that the return on stocks is determined by the productivity of the U.S. economy rather than by some sort of market negotiation.

Different things control the investor return at different times. In the short-term, it’s investor emotion that sets prices (and, thus, returns). At 10 years out and 20 years out, it’s valuations that determine returns. At 30 years out and 60 years out, it’s the productivity of the U.S. economy that is the most important factor.

Where is the evidence that market returns are set through some sort of market negotiation (that investors are rewarded for taking on risk)? There is none. There never has been any. This has always been just an assumption. Moreover, It is an assumption that is not supported by either common sense or the historical record.

The evidence supports a belief that the stock return is determined by the profit-generating potential of the underlying businesses. That’s where the money comes from that shareholders receive in the way of returns.

There’s an old saying from Watergate days that reporters need to “Follow the Money.” Follow the Money here and you see that stock returns are ultimately a function of the profits of the underlying businesses. There is no market negotiation going on. That is a one of the “myths and urban legends” of the Buy-and-Hold model being criticized by Rob Arnott in his recent criticism of this model.

Rob

At 30 years out, the starting-point purchase price has a small effect. But for practical purposes I would say that valuations don’t matter much at 30 years out.

So if my investment horizon is longer than 30 years I should ignore this Valuation Informed Indexing malarkey?

So if my investment horizon is longer than 30 years I should ignore this Valuation Informed Indexing malarkey?

The “marlarkey” thing is emotion, Evidence. None of us follows every strategy we hear about. We take what we like and leave the rest behind. To evidence hostilityto a strategy that lots of other people find valuable is a sign of a lack of confidence in the strategies that you have elected to follow. You need to get over that. Hate is not a sound long-term investing strategy. I’m sure of it!

The way that I would say it is, if there is a portion of your money that you are not going to make any use of for 30 years, you are virtually certain to get a solid return for putting that money into stocks regardless of valuation levels.

If you follow a Buy-and-Hold strategy for your entire portfolio, you need to be prepared to deal with a loss of 80 percent or more of your entire portfolio (the loss was 80 percent when we got to a P/E10 level of 33, but we went far beyond that in the late 1990s). Not recommended.

But, if you are talking about keeping 20 percent in stocks regardless of price, I think that makes good sense. Even an 80 percent loss on 20 percent of your money is not necessarily a huge deal. And, yes, so long as you hold those shares for 30 years, you will end up with a good return in the event that stocks perform in the future anything at all as they always have in the past.

Rob