Yesterday’s blog entry reported on two e-mails that I sent to Academic Researcher Wade Pfau on March 1, 2011. Wade sent his response the same day.
He said: “I think having that debate with Mel helped me to clarify some stuff in my mind, which I can more or less copy and paste into my paper after making some adjustments so that it sounds more “academic.”
In response to my suggestion that he consider looking at hypothetical portfolios that employed stock allocations of greater than 100 percent at times of low valuations, he said that this would not be difficult to do and that he would plan to do it in a future paper but not in the one he was preparing at the time. Wade told me that, based on the analysis of the historical data that he had been doing, “I would not be surprised if the market timer had to go all the way to 200/0 to get a strategy with the same risk as 100% stocks.”
He added that: “The fact that you should only compare risk-adjusted returns is very basic in finance. Academically, it is clear in Markowitz’s work from the 1950s. But no one was acknowledging that they agree about this.”
I sent my response the next day. The text is set forth below.
In the main paper, will you be able to use some of the tools you referred to in the Bogleheads post? I am referring to the risk-oriented ones (for example, the one that said the highest drop experienced for 100 percent stocks was x and the highest
drop experienced for 100/0 stocks was y)?
If you are able to do that, it would make me very happy. The discussion over whether that matters or not goes back to the very first day — May 13, 2002. I have been saying that VII must bring better numbers (I said this long before anyone knew what the numbers were — I’ve never viewed the numbers as being anything more than CONFIRMATION of what common sense tells us must be so) but I also have made a totally separate argument — that the numbers shown for VII are realistic while the numbers shown for Buy/Hold are not because there are probably only a tiny number of investors in history who have stuck to Buy/Hold through an entire Bull/Bear cycle (at the moment of biggest loss from 1929 forward, the real loss was 80 percent real — it’s a rare individual who could stick with a high stock allocation through that).
John Walter Russell provided huge help in showing that the numbers for VII are better than for Buy/Hold (although I think your rolling 30-year period showing is more compelling). But I was either never able to explain the other point successfully to John or he was not familiar enough with the tools needed to make the point effectively (he was a systems engineer). He tried a few things but our efforts on this second point never produced much usable material. My focus has always been on the emotions side rather than the numbers side. So in my mind this is actually the bigger point (I have generally given up putting it forward largely because I have not been able to find statistical support for it and in this field that often seems to be the only sort of evidence that “counts”).
I would love to see more support for that point (I am certainly not trying to push here, I am just saying that I would be grateful to see it if there comes a day when it is something that can be provided).
There was an amazing conversation I once had with John Greaney, the Supreme Leader of the Goons, back at the Motley Fool board. The largest real loss in the record is 80 percent. John retired at age 41 and used his Old School SWR study to plan his early retirement. He retired with about $500,000 (that went to about $3 million during the bull years). I asked him what he would have done if, in the first three years of his retirement, the value of his portfolio had fallen to something not much above $100,000 (he goes with a 90 percent stock allocation). He said that he would have just stick with his 90 percent stock allocation because his SWR study proves that his plan cannot fail (that stocks would turn around and he would make all the money back plus a lot more).
My response (this was early 2003) was: “I’m going to take a brief Screaming Break now, everyone. I’ll be back in a little while.” I am certain that there were others in the room who agreed with me. But no one else dared to speak up.