My last blog entry reported on an e-mail that I sent to Academic Researcher Wade Pfau on March 17, 2011. Wade’s response arrived on March 21, 2011.
He said that he was back in Iowa and “I was thinking about how much happened in the two months since I was last there.”
In response to my comments, he said that “the trouble with TIPS is that they have such a short history…. The 3.5 percent you locked may have been an exception that will rarely ever be seen again. Ex ante, TIPS shouldn’t provide higher returns than traditional bonds.”
He also said that: “It would hardly be fair to say that the buy-and-hold guy panics and sells stocks at the same moment the VII guy decides to calmly increase his stock allocation in spite of the general panic.”
Wade reported that his paper on safe savings rates would be in the May 2011 Journal of Financial Planning. He observed that: “As I now cited The Retirement Risk Evaluator in the revised paper, you will soon be able to say ‘as featured in the
pages of the Journal of Financial Planning’ :)”
I responded the same day. The text of my e-mail is set forth below.
It makes me very happy to be able to say “as featured in the Journal of Financial Planning.” That’s super.
I completely agree that the 3.5 percent real return for TIPS was extraordinary and that it would not be fair to use that number as the non-stock return. My thought is that it is equally unfair to use the return for commercial paper as the non-stock return. It would also be extraordinary for an investor seeking an alternative to stocks to turn to commercial paper. There’s rarely been a time when a 3.5 real return was available. But has there ever been a time when a reasonably intelligent investor could not find some non-stock asset class paying more than commercial paper?
I got out of stocks in the Summer of 1996. I don’t believe TIPS were available at that time. I invested in five-year CDs paying 7 percent real. I believe that the inflation rate for those five years ended up being less than 3 percent. So I earned in excess of 4 percent real. That’s a BETTER return than the 3.5 percent real I later earned in TIPS. It was of course also more risky because I didn’t know in advance that inflation for the five years would be less than 3 percent. But I think it’s fair to say that the value proposition for CDs at the time was better than the value proposition for commercial paper at the time. So someone looking for an alternative to stocks was not going to be investing in commercial paper.
The proper way to do this (in my view) is to develop a realistic sense of what the best available non-stock return is on average and then just use that as the non-stock return. I am not saying that you personally should do this at a time when no one else is doing it. I am saying that I think this is the theoretically proper way to do things. No intelligent long-term investor invests in commercial paper and using this as the non-stock return pulls down the return differential for those willing to move out of stocks at times.
Again, I am not saying you should buck the convention on this. That would no doubt cause raised eyebrows, which might make the effort to achieve the larger purpose that much more problematic. It might be, though, that there is a separate paper in testing different ways of assigning a return to non-stock asset classes and examining the pros and cons of each.
Are there any academics who do not follow the convention or who at least question it? My guess is that the proper number for non-stock asset classes is a return somewhere between 2 percent real and 3 percent real. It would be a rare circumstance where some asset class did not supply 2 percent real. And a risk-free return of greater than 3 percent is also available only in rare circumstances.
One last point that needs to be made in this connection is that, if we really believe that the 4 percent real return that was available for TIPS in 2000 was so extraordinary (I do), why weren’t we publicizing this point in 2000? Why weren’t we telling investors that a once-in-a-lifetime opportunity was available to them? We can check what the experts were saying at the time through use of the internet. Most were saying that TIPS were kinda, sorta okay at best. It was a rare investing expert who was warning his readers not to miss out on the great deal available at that time.
Even that fact highlights the bias toward stocks that in my view is present in just about all investing research. Methodologies are set up in ways to slant things in favor of stocks, and, not surprisingly, they generate results that appear to favor stocks. When more realistic assumptions are used, very different results are generated.
It IS fair to say that the Buy-and-Hold guy panics and sells stocks at the same moment the VII guy decides to calmly increase his stock allocation in spite of the general panic. The entire point of VII is to keep your risk profile stable and thereby to protect yourself from experiencing emotional reactions to price changes. This is a more important benefit of this approach than the higher returns and diminished risk that happen to go with it as well.
Investor A, who has 80 percent of his accumulated savings of a lifetime in stocks, does not respond in the same way to a 50 percent drop in the price of stocks as Investor B, who has 20 percent of his accumulated savings of a lifetime in stocks.
It is NOT reasonable or fair to assume similar emotional reactions.
To understand why the crazy assumption has become so common, you have to appreciate the core premise of Modern Portfolio Theory. The core premise is investor rationality. It’s Adam Smith economics applied to stock investing. They ASSUME that investors always act in their own best interests.
If investors always acted in their own best interests, stocks would always be priced properly, risk would be stable, and Buy-and-Hold would be the perfect strategy. The logic chain is solid. The problem is that the premise is false.
Investors are NOT rational. They are human (a combination of the rational and the emotional). We know this because stocks are often mispriced. There can never be a rational mispricing of anything. The rational price is the proper price.
If investors were rational, the P/E10 value would always be 15. P/E10 is a number that reports to us the extent of irrationality present in the market price at any given time.
The reason why Buy-and-Holders don’t like to make adjustments for P/E10 is that they sense that incorporating a consideration of investor irrationality into their system will cause the system to collapse. They are right about this. You can’t believe in both Modern Portfolio Theory AND that P/E10 effectively predicts stock returns.
People have been trying to find some middle ground for 30 years now. That’s the cause of all the confusion. The reality is that either Fama is right or Shiller is right. It is a logical impossibility that both are right. The reason why our knowledge of how stock investing works has not advanced much for 30 years is that the Fama forces do not want to acknowledge defeat at the hands of the Shiller forces and for practical purposes did not need to do so for so long as the bull market remained in effect. Since the crash, the battle has been swinging in the direction of the Shiller forces in a big way although we’ve still got a ways to go for sure.
The bottom line is that either valuations (emotions) matter or they don’t. If valuations (emotions) matter, then everything we have come to know about how stock investing works in recent decades is wrong.
Once we accept that valuations ((emotions) matter, the natural next step is to measure HOW MUCH they matter. What we find is that the effect is HUGE. Getting the emotions under control is the key to long-term investing success.
The primary purpose of VII is not to obtain higher returns or to diminish risk., The primary purpose is to get the emotions under control (this is done by keeping risk constant). The investor who has his emotions under control is NOT going
to respond to events in the same way as the investor who does not have his emotions under control. Research methodologies that assume that he will are not going to produce findings that stand up to long-term scrutiny (this is obviously not intended as a personal dig, I of course get it that all of today’s research is marred by this flaw).
There are two ways we can deal with our emotions. We can ignore them or we can attempt to come to terms with them. The Buy-and-Holder ignores them. This creates the ILLUSION that he has things under control. But the investor knows on
some level of consciousness that his confidence in his strategies is misplaced. The Buy-and-Holder evidences bravado, not genuine confidence.
The Valuation-Informed Indexer appreciates how hard it is to possess full self-knowledge. So he never pretends to possess the level of confidence that the Buy-and-Holder insists he possesses. But the humble confidence of the Valuation-Informed Indexers is authentic. So it produces better long-term results.
The Buy-and-Holder is shocked by a price crash and thus panics in response to it. The Valuation-Informed Indexer understood years in advance that the crash had become inevitable and thus had anticipated it and prepared for it. There is nothing for him to panic about or even to be surprised about.
As for the practical problem of how to incorporate such an idea into research, my guess is that there would need to be a variety of assumptions tested. One of the risk measures you have used is “the largest portfolio decline experienced.” You could have an assumption that the investor sells all stocks and stays out of stocks for 10 years after experiencing a portfolio decline of x. This would show that Buy-and-Hold is devastating in worst-case scenarios.
The tough part is coming up with assumptions that all view as reasonable. The only thing I can suggest here is testing a variety of assumptions so that people can just decide for themselves which one they want to look at.
The assumption that Buy-and-Holders will stick with their allocations has NEVER been tested in the real world (Buy- and-Hold became popular in the late 1970s and until 2008 we had not experienced a general crash since then — we still
have not experienced more than 50 percent of the price drop we locked in by our tolerance of the last bull market). We can look at the price drop in the late 20s and early 30s and speculate as to what percentage of Buy-and-Holders would have stuck with their allocations. The real loss from high to low point was 80 percent real. I think it is fair to assume that the percentage that stuck was a very small number.
And every Buy-and-Holder faces a 1929-type situation in his investing lifetime. We have had four of these from 1900 forward (the early 1900s, the early 1930s. the mid-1960s and the 2000s). If you invest for 60 years (from age 25 to age 85), you are certainly going to need to live through one crash and probably two. If you don’t know why it is happening, you are going to pull your lifetime return down dramatically by selling at low price and then remaining out of stocks during the years when they provide their best returns). If you understand what is going on, you can prepare yourself emotionally and thereby pull your lifetime return dramatically up.
Emotions affect returns. Fully accurate research takes this into account. People who like Modern Portfolio Theory don’t like considering emotions (MPT is a hyper- rationalistic approach). But there is just no other way to get things right. Investing is done by humans and humans possess emotions. Emotions are REAL FACTORS in all economic analysis.