I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.
Scott Burris, Director of the Center for Health Law, Policy and Practice at Temple University Law School, sent me a response saying: “I found the piece interesting — what one would expect from a Temple grad. I read the Pfau paper. Good luck with your endeavors.”
I wrote back: “Thanks for your kind wishes!”
“This is what I wrote to my investment advisor. Did I correctly understand the argument?
“The Pfau paper addresses a point that, in my casual observation of the market and investment strategy, had also occurred to me: that the fact that aggressive and short-term market timing was unproductive did not mean there were never times that it would be wealth-maximizing to get out of the market. The challenge, of course, was to figure out the moment. This piece tests the use of a ten year average of PE ratio, and finds results comparable to buy-and-hold when adjusted for risk. This approach seems particularly applicable to people hitting their sixties, for whom shorter-term risks matter more. It’s notable, for example, that someone who’d followed this approach for a few decades would have gone to t-bills in 2009 and so, if they were about to retire, would have been richer and happier in 2010-11 and would still likely have been back in stocks in time to get some of the recent appreciation. Finally, in an era of economic financialization and weak regulation, one might expect a return to our pre-1929 pattern of frequent boom and bust cycles, suggesting, again for the retiring person, more of the unfortunate short-term effects of volatility.”
Yes, you understand the point. All of the things you say in that paragraph are accurate.
My personal view is that there is an even broader implication. The root question here is: How are stock prices determined? The conventional view is that it is a day’s economic and political developments that determine whether prices go up or down and by how much. The Shiller/Pfau research shows that this conventional view cannot be accurate. If the conventional view were accurate, prices would follow a random walk in the long term, just as they do in the short term. The research shows that long-term prices are highly predictable. The really important question is — How can that be? How can we know years in advance what stock prices will be?
The answer is that investors hold two opposite ideas in their heads at the same time. We all have a Get Rich Quick urge. So we very much want to believe that temporary and crazy bull market prices are real. We also all have a Common Sense urge. The Common Sense urge tells us to reject the temporary and crazy bull market prices. We SUPPRESS the Common Sense urge for the length of the bull market. Eventually, though, the Common Sense urge strengthens enough to gain the upper hand. That’s when prices crash. Crashes make no logical sense. All price changes should be gradual if the market is responding to economic or political developments, which play out gradually over time. But emotional changes can be violent. Crashes make sense in a world in which the dominant influence on price changes is investor emotion.
This means that 80 percent of the research being produced today looks at the wrong things. Most investing research is numbers-oriented. If it is an understanding of investor emotion that determines success or failure, we need to be looking at all sorts of thing that today we ignore. For example, we shouldn’t be blaming the stock crash on our economic problems. It is our lack of understanding of how investing works that caused our economic problems. Trillions of dollars are tied up in the stock market. The stock market is part of the economy. To successfully manage the economy, we first need to permit ourselves to learn more about how stock investing works. The first step is acknowledging that we did not know it all before Shiller and Pfau did their research.
This turns everything we think we know about stock investing on its head. It’s because the implications are so far-reaching that people are reluctant to discuss this. But the news is good, not bad! It’s true that we got a lot wrong. But that just means that we have lots of room for improvement. We have ignored Shiller’s research for 30 years. Imagine where we would be in the computer technology field if we determined in 1981 that every advance possible had already been achieved and that no further advances would be permitted. That’s what we have done in the investing field. If we open up discussion on all the advances that we achieved intellectually over the past 30 years, we would see 30 years of knowledge advancement in a very short amount of time (and these are the best 30 years of knowledge advancement we have ever seen in this field).
It’s impossible to overstate the importance of this (presuming the insights are valid). Look at the risk chart Wade provides on Page 8 of his paper. The Portfolio Drawdown Percentage goes from 60 percent to 20 percent with the move from Buy-and-Hold to Valuation-Informed Indexing. That’s a risk reduction for stock investing of nearly 70 percent! For investors who index and who pay attention to valuations when setting their stock allocation, stocks are today not much more risky than Certificates of Deposit. That changes everything.
One last practical point. The best way to think about this is not to say “there are times when it is a good idea to get out of the market.” It’s not possible to know precisely the right exit and entry points. P/E10 told you that stocks were insanely dangerous in 1996 and returns were amazing in 1997 and 1998 and 1999. The way to think about his is to say “risk is greater when the P/E10 level is greater and so I need to gradually lower my stock allocation in response to increases in the P/E10 level to keep my risk profile roughly constant.” The full truth is that, while stocks did well in 1997 and 1998 and 1999, the investor who lowered his stock allocation in 1996 is ahead of the game today. And he will be farther ahead after the next crash (every secular bear market in U.S. history eventually took us to a P/E10 level of 7 or 8, 65 percent down from where we are today. We cannot pick tops or bottoms. But we don’t have to. It’s risk that matters. We MUST manage risk. Those who follow Buy-and-Hold strategies are vowing NOT to manage risk as their first investing decision. That always ends up being a terrible choice in the long term.