Tom Drake, owner of the Canadian Finance Blog, yesterday put forward the following words in the discussion thread following my Guest Blog Entry titled The Five Big Benefits of Valuation-Informed Indexing:
Hi, thanks for the informed discussion. After reviewing some of this material I feel like I am missing something. The approach seems to jive with all the value based investing learning I have been engaged in; including Ben Graham, Jarislowsky, Kyle, Green, Motley Fool, Josh Peters, Geraldine Weiss, Browne. Sounds like bottom up value investing to me, entry point very important, adjustments to allocations important. So why all the controversy? Why the bans? What am I missing from the strategy?
Set forth below are the words that I posted in response:
That’s a super question, Tom. Thanks for asking it.
Valuation–Informed Indexing is a COMBINATION of the insights of Buffett (Value Investing) with the insights of Fama/Malkiel/Bogle (Buy-and-Hold). I view Value Investing as the best of all investing strategies. I also think that Bogle did something huge in coming up with an approach simple enough to permit the typical middle-class worker (who has little desire to research stocks) to tap into the benefits of stocks. But Buy-and-Hold cannot work long term without a valuation component. The idea here is to make Buy-and-Hold workable in the real world.
In an intellectual sense, there is nothing even the slightest bit controversial here. You are 100 percent right about that. None of the people who insist on bans dispute that valuations affect long-term returns. There is no disagreement as to what the research says.
The controversy is rooted in concerns over the practical implementation of the finding that valuations affect long-term returns. When financial planners use safe withdrawal rate analysis to help people plan their retirements, should they include a valuation adjustment in the analysis? If no adjustment is included, the SWR is always 4 percent. If one is included, the SWR varies from 2 percent at times of high valuations to 9 percent at times of low valuations. For someone with a $1 million portfolio at the time of retirement, that’s the difference between living on $20,000 in every year of the rest of his life or living on $90,000 in every year of the rest of his life.
If valuations really affect long-term returns (there is today a mountain of research showing that they do), the Old School SWR studies have caused millions of middle-class people to plan retirements that are almost certainly going to fail. And the asset allocation advice given in 90 percent of the investment books available today is wildly wrong. And the risk management advice is wrong. And on and on.
To understand what is going on, you need to appreciate the history of how our knowledge of how investing works has developed over time. Research showed in the 1960s that short-term timing never works. This was a huge advance. Unfortunately, most researchers of the time did not see the need to distinguish short-term timing from long -term timing. So the interpretation of the finding that short-term timing does not work was that “timing doesn’t work” (the finding is correct but the interpretation is wildly wrong).
Then Shiller did research showing that long-term timing ALWAYS works and in fact is required for long-term success. This finding is ALSO of huge importance and needs to be integrated into the mix (investors need to be told both to avoid short-term timing and always to be certain to practice long-term timing). But the Buy-and-Hold advocates don’t like even a tiny little bit the idea of acknowledging that they made a mistake.
You are right to note that Buffett (and all Value Investors) were aware of the importance of valuations going back to the first day. Had Fama and the others paid more attention to Buffett, they never would have gotten us into this mess. They didn’t. They created academic models that improperly ignored Buffett’s insights.
Shiller’s research essentially incorporates Buffett’s insights into the academic research. We now have two camps taking the academic research down two opposite paths. The Fama camp lives in the imaginary world where the market is efficient and thus valuations don’t matter. And the Shiller camp lives in the real world where valuations are the most important thing that an investor needs to look to in setting his stock allocation.
Both camps are analyzing the same data and yet coming to wildly different conclusions on every practical investing question. The reason is that they are starting from opposite premises. One camp calculates all its numbers with zero consideration of valuations. The other includes valuations in its analyses and thereby learns that valuations are by far the most important factor bearing on just about every question examined.
There is zero dispute re the facts. But there is a HUGE controversy as to whether the facts as we know them today may be REPORTED on public investing boards and blogs.
Note: It turns out that it was not Tom Drake who wrote the words that are the focus of this blog entry. It was another community member named “Tom.” Knowing that Tom Drake is the owner of the blog, I jumped to the improper conclusion that it was Tom Drake who wrote the words. I apologize to Tom Drake, to the other Tom and to all community members who have read the blog entry for the confusion I have caused.
Tom Drake told me in his note that he has no objection to being identified as the author of the words put forward by the other Tom. Tom Drake is as confused as the other Tom (and as many others, no doubt) as to why there is a Ban on Honest Posting on the realities of stock investing in effect today at numerous discussion boards and blogs. The reason why I put forward the blog entry when I was under the impression that the words were those of Tom Drake is that it is a significant development that there is now an influential blogger willing to ask questions about the ban. For many years now many personal finance bloggers have kept mum about this.
Given that Tom Drake says he agrees with the author of these words, I have elected to leave the headline of the article as I wrote it while adding this note explaining that he was not in fact that author of them at the time they were put forward in a blog comment (but signed onto them only afterwards).
I look forward to the day when the entire Personal Finance Blogosphere takes a strong stance in opposition to continuation of the Ban on Honest Posting, permitting all of us to direct our full energies to examination of the important substantive issues in question here. It is my sense that we are making slow progress in our journey to that wonderful place where we all deep in our hearts want to be.