VII #26 — The Numbers on Your Portfolio Statement Are Wrong!

I’ve posted Entry #26 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Numbers on Your Portfolio Statement Are Wrong!

Juicy Excerpt: This one puts me on the spot. If I say “yes,” I sound like a crazy person. If I say “no,” I contradict my claim that valuations need to be taken into consideration when calculating safe withdrawal rates and when performing all others sorts of investment analyses. If valuations matter, they always matter. If valuations don’t matter when determining how much a mutual fund company should pay you for your shares, it cannot logically be argued that they matter in other contexts.

I say “yes,” Vanguard should discount the portfolio value for the extent that stocks are overvalued at the time shares of an index fund are sold. This will indeed make me sound like a crazy person in the ears of many. But you know what? This isn’t the first time this sort of thing has happened. And you know what else? I think it makes sense to discount the nominal amount of the portfolio to reflect the effect of overvaluation. I think that if we made that change, it would lead to all sorts of good things.

Comments

  1. says

    Hi Rob

    I totally agree with the position that valuations matter (a lot) and should be taken into account when doing retirement planning exercises (such as calculating SWRs) as well as investing generally.

    However I really struggle with this one as much for practical reasons as others. Specifically, different people will have different retirement needs and circumstances. At least some of those will result in the correct number being different for different individuals. As an example, current prices would be highly relevant to a person who intends to withdraw this year for retirement living expenses while future expected returns (which depend at least in part on valuations today) will be more relevant to someone who will not be looking to draw down on their savings for decades to come.

    IMHO it will be too much to expect the intermediaries to be able to model for every individual. In addition, “one size fits all” is not something I would feel comfortable with when it comes to retirement planning.

    I can also see some behavioural issues affecting investors if this approach is adopted (which may or may not be a good thing) and opportunities for intermediaries to game the calculations for their own purposes (which would be a bad thing).

    It may be more practical to continue providing statements based on current mark to market supported by a range of potential discounts based on prevailing valuations and time horizons. There would need to be some form of standardisation of the basis of calculation or there will be a lot of confusion (well, an increase in confusion) with different intermediaries providing different numbers for the same portfolio.

    Of course, if the markets are low enough, it may be a case of providing a range of premiums (!) rather than discounts …. which is probably a good way to get sued.

    It might just be easier to stick with statements of current market value and educate people how to do their own basic modelling (an on-line calculator) based on their own circumstances.

    As a side note, thanks for all the very useful information you provide on this site.

    Cheers
    traineeinvestor

  2. Rob says

    You have put forward a highly intelligent and helpful comment, traineeinvestor. You’ve put your finger on something of great importance.

    The logic here is inescapable. If overvaluation means anything, it is wrong to charge people the full nominal price for greatly overvalued stocks. When you do so, you are charging them the wrong price! How could that be right? They are handing over $1,000 and getting back something worth only $500.

    The practical problem is also inescapable. As you point out, if you adjust prices for valuations, you will at the bottom of bear markets be giving people half as much stocks per dollar paid as they think is proper (because the stocks are worth twice as much as they think).

    We either have to defy logic (which is what we are doing today) or we have to do something that is a practical impossibility (giving people half as much stocks per dollar paid as they think is proper just will not fly). What to do, what to do?

    I believe that the answer is to start moving in the direction of taking valuations into consideration by doing the things that ARE practically possible. For example, we could continue using nominal price to determine how much to charge but include on the statement a notation that the stocks are worth only x when a valuation adjustment is applied. This would change people’s thinking about these matters. And a change in thinking would cause all the problems to go away.

    Eugene Fama is right in theory. The market SHOULD be efficient. Stocks always SHOULD be priced properly. What he missed is the irrationality of the humans, What we need to do is to put in place reminders of the importance of valuations. If we provide enough reminders, people will get it. Then the problem simply goes away. There is no more practical difficulty at that point because stocks are always priced more or less right.

    I agree with you that there can never really be a world in which stocks are being sold at a price other than the nominal price. That’s too crazy. I bring the point up as a mental exercise — taking into consideration how insane it is to sell stocks at wildly wrong prices as a daily business practice highlights how crazy we have let things get by ignoring valuations in so many ways for so many years.

    Correction of the nominal price is the last step in the path leading to sanity, not the first. Early steps are to fix the Old School SWR studies and to permit honest posting on all aspects of the stock investing project at all discussion boards and blogs. Once everyone is on the same page re the importance of valuations, the mispricing problem will go away. Remember — there is not one investor alive who wants to invest ineffectively. We all are highly motivated to become Valuation-Informed Indexers, once we are permitted to see how much it would enhance our enjoyment of life to do so.

    The problem we have is a circular one. We have denied ourselves the benefits of knowing the realities of stock investing for so long that we cannot bear to acknowledge that we have been doing this. That’s why we are stuck in a ditch today. But investing has become so important a matter in our new economy that having most investors follow strategies that are the opposite of what the entire historical record shows to be what works now threatens the continued viability of the free market economy. We need to make a choice to move in the direction of permitting discussion of rational investing strategies.

    Once we do that, it’s over. Once it becomes possible for people to become rational about investing, it becomes possible for the market to price stocks properly. Remember — The market is comprised of people! Once the market prices stocks properly, all these other problems go away. There is simply no need for stocks ever to be overpriced or underpriced. There is no need for volatility. There is no need for stocks to be risky. All of that junk is the product of the irrationality of Buy-and-Hold thinking. We are capable today of putting all that stuff behind us.

    Many have a hard time accepting that stocks could become a virtually risk-free asset class. But you know what? People once had a hard time accepting that electricity could permit us to light our homes at night. And people once had a hard time accepting that computers could ever be made small enough so that they could be owned by anything other than huge corporations. And people once had a hard time accepting that airplanes would permit us to fly across the oceans.

    People ADVANCE over time. This is what humans do. This is what makes life interesting. Valuation-Informed Indexing is an ADVANCE over Buy-and-Hold. All of the controversy we see on this topic is the product of the reality that the advance being accomplished here is so huge. Huge advances scare people.

    The other side of the story is that huge advances are the sorts of things we need to get ourselves out of the sorts of economic crises that we bring on when we convince large numbers of people that Buy-and-Hold strategies can work. It’s the bad stuff that we are going to experience as this economic crisis worsens that will be opening our minds to all the good stuff that becomes available to us once we permit honest posting on safe withdrawal rates and many other critically important investment-related topics.

    That was a super point you made, traineeinvestor. I hope you will pay us future visits. Your blog (please follow the link at traineeinvestor’s name to get to his blog) looks like it provides lots of fine insights on all sorts of matters. Thanks for stopping by.

    Rob

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