I’ve 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.
Yesterday’s blog entry reported on my e-mail correspondence with Economics Professor Valeriy Zakamulin. Set forth below is my response to the e-mail detailed in yesterday’s report:
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Valeriy:
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You are making great points and asking important questions. Thanks for being willing to get down to the nitty gritty of all this.
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What I believe in might be termed a “Conspiracy of Ignorance.” I believe that the humans gradually acquire knowledge over the years. We start out not knowing and then over time we come to know. I don’t think that people are meeting in a dark room and crafting plans to trick everybody. I believe that people misunderstand how stock investing works and pass along their misunderstandings when they share what they think they know with others.
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I believe that the Efficient Market Hypothesis was an advance over what we had before. It was a tool that helped us advance. But I also believe that belief in it has become dogmatic and the dogmas are holding us back.
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I understand the point you make about the default belief (the “presumption of innocence”). Ideally, there would be no default belief. We would just tell people what we know for sure and let people make decisions based on that. The trouble is, it is the most fundamental question of all (how markets work) that causes the most uncertainty. Buy-and-Holders believe that the market is efficient. If that’s so, stock investing risk is stable and staying at the same stock allocation at all times is the ideal strategy. But what if this is not so, what if valuations affect long-term returns? If that is so, then risk is variable and Buy-and-Hold is the most dangerous strategy imaginable (if millions of investors elect to remain at the same stock allocation when they should be lowering their stock allocations to keep their risk profiles constant, the collective losses will be in the many trillions of dollars and will cause an economic crisis and in time a Second Great Depression).
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So which is it? As a society, we do not know. My belief is that valuations affect long-term returns, that the market is NOT efficient. But there are millions of good and smart people who believe just the opposite, who believe that Buy-and-Hold is a 100 percent sensible and responsible strategy. So, in the practical realm what do we do? We cannot tell people to hold off on investing for retirement until we all agree on which approach is best. Given that we do not all agree what is best, what should we tell investors to do?
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It seems to me that the presumption should be that valuations affect long-term returns. All that long-term timing is is paying attention to price. There is no other good or service that we can buy for which price does not matter. Why presume that stocks are the one exception? Plus, we have the fact that for the 140 years of historical data available to us, price always HAS mattered; the data confirms what common sense tells us must be so. In contrast, Buy-and-Hold has never worked in the long-term. Those who stay at the same stock allocation always face a wipeout sooner or later; prices gradually rise higher and higher and higher (because so few are paying attention to price!) and eventually the market crashes and we all lose (even those not invested in stocks suffer in the economic crisis brought on by the huge loss of collective wealth experienced in a stock crash).
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I believe that the Efficient Market Hypothesis was a powerful insight containing one huge flaw that is now in the process of killing us. The hypothesis ASSUMES investor rationality. Shiller’s research shows that investors are NOT rational. What fools people is that the irrationality of investors does not do us much harm in the short-term. From 1982 through 1996, stocks were priced to provide a strong long-term value proposition. Buy-and-Holders were going with high stock allocations for different reasons than Valuation-Informed Indexers but the practical effect (good returns) was the same for both groups of investors. It was only with the 2008 crash that Buy-and-Holders were able to see in a concrete sense the danger of staying with the same stock allocation at all times (and of course the next crash — Shiller’s work suggests that prices will drop another 65 percent over the next few years — will bring the point home in a truly terrifying way).
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The Buy-and-Hold Model (rooted in a belief in the Efficient Market Hypothesis) permits researchers to study all aspects of the investing experience that can be examined through the use of logic. But the the most important thing we need to study is RISK and the risk of stock investing is rooted in the human inclination to let emotion influence one’s allocation choices. We need to give ourselves permission to discuss RISK in a frank way and that requires that we talk about things not acknowledged by the Efficient Market Hypothesis. The P/E10 metric is a tool that lets us reduce investor emotion (risk) to a number. Stocks were priced at three times fair value in 2000, according to the P/E10 metric. This means that the investor who thought that he had a portfolio value of $600,000 in reality had a portfolio value of $200,000. Big difference! That investor’s illusions caused him to make all sorts of bad financial planning decisions. Those illusions caused him to ruin his life. But the researchers in this field never talk about that aspect of the question! They talk about numbers. To understand investing, they need to talk about human emotions. It is the human desire for self-deception that is the driving force behind all bull markets and it is bull markets that make stock investing risky (there has never been a price crash of long-term significance starting from a time when stocks were selling at low or moderate prices).
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The problem we have is a circular one. The experts say that Buy-and-Hold can work because this is what people want to hear. And the people want to hear it because in an earlier time they were persuaded by the experts that Buy-and-Hold could work and now their retirements are riding on it. How do we break the circle? The researchers should be warning people of the dangers of Buy-and-Hold in a world in which the Efficient Market Hypothesis has been discredited (if Shiller is right, the Efficient Market Hypothesis is wrong). Most are not doing this. When researchers fail to point out the dangers, people assume that the advice they are hearing from the experts must be more or less okay. In reality, it is as dangerous as all get-out. The researchers are not paying attention to how their research is being used — it is being used to prop up long-discredited (even if once promising) ideas.
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Here is a blog post in which I report on an e-mail I received from Rob Arnott:
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I find it a scandal that researchers were intimidated into not doing research they believed was important. How can we advance knowledge if we are afraid to look at the most important questions? Who is it that is sending the hate mail to these journals? Scientists? Is the sending of hate mail part of the scientific process?
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These sorts of things don’t happen only to Rob Arnott. When I was working with Wade Pfau, he was like a kid in a candy store, discovering new insights on a daily basis and getting more and more excited about where he could go with them. Now he feels that he dare not explore any of those insights. Please look at the quotes at the bottom of this article (the longer version of the article I linked to in my first e-mail to you)
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and see what Wade said about the work he was doing at the time. He was AMAZED that no other researchers had engaged in these sorts of explorations. He couldn’t make sense of it. Now he knows. Other researchers don’t look at these questions because it is a career-limiting move to do so.
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Even Robert Shiller has experienced intimdation. Shiller has said in interviews that he has never told us all that he knows about how stock investing works because he knows that he would be branded “unprofessional” if he were to do so. Huh? An economics professor at Yale doesn’t feel comfortable sharing what he knows about a critically important subject that he has studied for decades? How could that possibly be a good thing? How could such intimidation tactics be part of a valid scientific endeavor? Intimidation tactics are not science. Intimidation tactics are the antithesis of science.
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I believe that this article
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is one of the most important “studies” even done in this field. Most people in this field won’t even refer to it as a “study” because it does not contain numbers and charts and tables. I say it is important because it tells the true story of the EMOTIONS of the Buy-and-Holders. That’s what we need to know about to advance our knowledge. That’s the missing piece. The market really does want to be efficient. Fama was close to getting it right. What he missed is that investors can behave rationally only if they have access to all the information they need to make good decisions. And, once we get into a bull market, as a society we formulate a SOCIAL TABOO that blocks us from engaging in discussion of the problems of overvaluation. We “know” that the inflated prices are real at the same time that we also “know” on another level of consciousness that they are not. The conflict between the two things we “know” drives us crazy and we evidence our craziness in the sorts of comments you see recorded in that article.
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I hope that I am making at least a little bit of sense, Valeriy. I am grateful to you for giving me an opportunity to at least take a stab at making sense to a kind and intelligent person who is well-informed about these issues.
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I do believe in a sort of conspiracy. But it is not the sort of conspiracy in which bad people meet in a smoke-filled room to craft plans by which to screw people over. It is a Conspiracy of Ignorance in which millions of people who deep in their hearts very much want to move on to a better place hold back from doing so because they are afraid of what they will find on the other side of The Big Black Mountain. I have been to the other side and I am here to report back that there are wonderful things to be found on the other side. My problem is that it is hard to convince people who have never seen these things how much we are able to advance our understanding of how stock investing works today. We now know how to make stock investing a virtually risk-free endeavor. Wade’s research shows that the Maximum Portfolio Drawdown Percentage drops all the way down from 60 percent to 20 percent (with no loss of return!) for those investors open to taking valuations into consideration when setting their stock allocations. We are on the verge of experiencing the greatest advance in our understanding of how stock investing works ever experienced in history.
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All we need is for people to calm down and let in all the good stuff. But people are afraid of the new. I can comfort them and reassure them and inspire them if I can talk to them. But the Buy-and-Hold dogmatics go crazy with fear whenever and wherever I try. And they use the studies of the academic researchers to justify their use of their intimidation tactics. So I need to report to the people affected by this (that’s every last one of us!) how the academic research is being used. It is being used today not to advance knowledge but to hold it back from advancing! I need to say that not because I do not like the researchers (I like them very much) but because it is so and because the intimidation tactics have brought on an economic crisis and because we must address this problem if our free market economic system is to survive.
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That’s where I am coming from, in any event. I hope that my venting has made at least a tiny bit of sense. Please do not think that in any way, shape or form I am aiming to criticize you personally. We are all (including me!) little parts in a big Machine. My job is to get that big Machine back on the right track so that all our work becomes productive and positive and meaningful and life-affirming and fun again. It’s a very hard job but it very much needs to be done and through a strange twist of events it seems that I was elected to take this one on.
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Please let me know of any thoughts that these words inspire. If I am off-base, I very much need to know how.
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Rob
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ADDENDUM A:
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On reading these words back, I see that I did not address your final point, that a move to money markets would cause a collapse. It’s true that a move out of stocks would cause prices to fall to fair-value levels and that that would be a significant drop from where we are today. The good news is that, once we let people learn how stock investing really works, we will never again see a drop below fair-value levels. In a rational world in which knowledge can be shared freely, stock prices are self-adjusting. High prices cause the value proposition of stocks to fall, which causes people to want to lower their stock allocations, which causes prices to return to fair-value levels. There never again will be bull markets or bear markets once we open the internet to honest posting on the implications of Shiller’s findings.
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The emotional approach (Buy-and-Hold), however, eventually causes prices to fall to levels far BELOW fair-value levels. Every secular bull in history has eventually brought us to a P/E10 level of 7 or 8, a 65 percent price drop from where we are today. Insane emotionalism in one direction always brings on insane emotionalism in the other direction. What we want is emotional (and market) stability and that can only be brought on by addressing the emotional conflict that I referred to up above. People will feel at ease about stock investing when they understand how it works and people will understand how it works when we produce lots of research showing that buying stocks is just like buying any other good or service, the price you pay ALWAYS, ALWAYS, ALWAYS matters. It is emotion that causes risk. And it is the belief that it is possible to invest in stocks successfully without taking price into consideration that causes emotion (no human is capable of having confidence in a strategy that ignores price because it defies common sense to believe that price might not matter).
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We WILL see a price drop if we open the internet to honest posting but it will be limited. The huge price drop we will see if we continue the cover-up will bring on the Second Great Depression. We can recover from a relatively small price drop and our new knowledge of how to make stocks a virtually risk-free investing class will then bring on an economic boom as millions of middle-class people learn for the first time how to finance their retirements in a truly smart, simple and safe way.
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ADDENDUM B:
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What I am suggesting re the “How Science Works” question is that the default belief be that price DOES matter, that long-term timing IS required. Price matters with every other good or service offered for sale. Why ASSUME that it works the other way around with stocks? If that were the assumption, people could still publish research trying to show that Buy-and-Hold works, but the default belief would be the opposite of what it is today. If people concluded that there was good evidence in both directions, they would go with a belief that the case for Buy-and-Hold (or the case for market efficiency) had not yet been made and that thus it was not appropriate to suggest that such a strategy could work. The root of all our troubles is this crazy assumption. There has never been a single study showing that long-term timing doesn’t work and common sense tells us that it MUST work. Why assume the opposite of what both common sense and the entire record of historical data tell us and then become dogmatically opposed to challenges to the crazy assumption?
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To make sense of this, I think we need to go back to the days when the Efficient Market Hypothesis was developed and examine why the mistake was made. My sense is that the problem is that index funds were not available at the time (Bogle formed Vanguard in 1976). Long-term timing only works with indexes. Since indexes were not available when the work was being done to see whether timing works or not, the researchers tested only short-term timing. When they learned that short-term timing doesn’t work, they jumped to a hasty conclusion that both forms of timing do not work (because in a practical sense there really was only one form at that time). It is my belief that, had Shiller published his “revolutionary” (his word) findings in 1971 rather than 1981, the name of the 1974 book would have been “A Valuation-Informed Walk Down Wall Street” and we today would be living in the greatest period of economic growth in our history instead of in the early years of the Second Great Depression. You see concern expressed about the national budget deficit all the time. But if you compare the numbers, the Buy-and-Hold problem is the far more serious one (the market was overpriced by $12 trillion in 2000 and even Bogle acknowledges that prices always return to fair-value levels with the passage of about 10 years of time — it is obviously not possible for any economy that loses $12 trillion of buying power in 10 years to avoid collapse).
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ADDENDUM C:
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My bottom line is that we all need to work together to launch a national debate on these questions. I obviously do not know it all. I obviously am one of the flawed humans. So anyone who goes solely by what I say is a darned fool. But what if there were thousands of people coming from all sorts of different perspectives and from all sorts of sets of life experiences addressing these questions with clear and frank and honest words? I think that would turn all this negative energy into positive energy. Say that Buy-and-Hold prevailed. That would be wonderful! By permitting the debate, the Buy-and-Holders would end up for the first time feeling a true confidence in their ideas. We should all want to see that happen if the reality is that Buy-and-Hold works.
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I don’t believe that it is even possible for people to know something that they do not feel free to talk about. We learn through discussion. So we MUST talk openly about these matters. It is this assumption that the market is efficient despite the 30 years of academic research showing otherwise that keeps people from talking openly. So I believe that that assumption must be challenged. I believe that we should give Fama full credit for his contribution, which was huge. But I also believe that Fama himself wants his ideas to bear good fruit and so on some level of consciousness Fama himself (and all those who follow his ideas) wants learning to advance. If Fama and Bogle and all the others on “that side” of things wants learning to advance, we ALL want learning to advance. So let’s do it! Let’s get about the business of learning together what really works! We should put an end to The Debate About Having a Debate and proceed to the actual debate that matters, the debate about how stock investing works in the real world.
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Rob
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