I have been contacting 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 correspondence with Robert Savickas, Associate Finance Professor at George Washington University Business School. Set forth below are the texts of two e-mails that I sent to Robert as follow-ups to the one described in the earlier blog entry:
Robert:
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Robert:
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I agree entirely that the short-term direction of the economy is unknown. My thought is that this does not matter for investors who are investing for the long term. People need to adopt the goal of maximizing the size of their portfolios over the course of a lifetime. VII does that. VII DOES cause poor results in the short term (Buy-and-Hold beat BII handily from 1996 through 2000). This is the price you have to pay to get higher long-term returns. The short-term really is not predictable but the long-term always is. Fortunately, it is the long term that matters.
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Re when to make changes. The VII principle is that the P/E10 level tell us the amount of riskiness inherent in stocks at any given time. Prices reached insanely dangerous levels in 1996. The investor would have done well to lower his stock allocation at any time from 1996 through today (with the exception of a few months in early 2009) because doing so would have lowered his risk. We don’t try to guess when turnarounds will come. We make the changes when the P/E10 level tells us they are needed to get our risk profiles right and then we wait patiently for the market to once again perform in the long term as it always has in the past.
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The Investor’s Scenario Surfer is a calculator that lets the investor work through as many 30-year returns sequences as he likes and to test how the strategy performs:
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http://www.passionsaving.com/portfolio-allocation.html
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I’ve run the calculator hundreds of times. I beat Buy-and-Hold in 90 percent of the cases. There have been cases where I have ended up with a portfolio of twice the size of the Buy-and-Hold portfolio. If you have trouble figuring out how the calculator works (it is not terribly intuitive, I am afraid), please just let me know and I will go through the steps with you.
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Re the point that paying attention to valuations makes sense. It does. But the Efficient Market Theory has been the dominant intellectual framework for a long time. If the market were efficient, it really would not make sense ever to change your allocation. Buy-and-Hold really does follow from from a belief in the EMT. The mistake was the EMT and the reasons why that mistake was made have never been explored in depth.
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I believe that the market WILL become efficient in days to come. The reason why the market is not efficient today is that our understanding of how stock investing works is so limited. For the market to be efficient, investors need to make choices that serve their self-interest. We today CANNOT make choices that serve our self interest because we just don’t yet know enough to do so. As more knowledge floods in, we will all make better choice and the market really will become efficient.
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When that happens, there will no longer be bull markets or bear markets, both of which are emotional phenomena. It is the Get Rich Quick impulse within all of us that causes bull markets and it is bull markets that cause bear markets. The key is getting the “experts” to acknowledge that valuations/emotions are proper subjects of study in this field. Once we study this stuff, we will learn how to avoid the obvious pitfalls. Right now, we are afraid to study the realities because we sense that discussion of the realities will bring on another crash.
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Re uncertainty/risk. The Valuation-Informed Indexer just doesn’t worry about the explanations of higher P/E10 values that are put forward during bull markets. The core idea is that it is unlikely that the long-term rate of return in an advanced economy wil change all that much. For 140 years, our economy has been sufficiently productive to support a long-term return of 6.5 percent real. We of course accept that this number might change to 6 percent or 7 percent in coming days. But it would take extraordinary developments for it to change too much more than that.
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The key to not getting caught up in the justifications for higher P/E10 levels is to do the math. Stocks were priced at three times fair value in 2000. How could U.S. productivity change that much? People just were not doing the math. I think it was a huge advance when the Buy-and-Holders rooted their strategy in DATA. That’s how we protect ourselves from the emotional subjectivism that makes stock investing risky. Unfortunately, the Buy-and-Holders failed to include the most important number of all (the P/E10 level) in their calculations and thus got all the numbers wrong. A numbers-based system that gets all the numbers wrong is the worst system of all!
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When you incorporate P/E10 into the calculations, you get an emotionally balanced approach. The Valuation-Informed Indexer is indifferent to whether prices go up or down. Each upward movement causes his portfolio value to rise but causes his expectation of long-term returns to fall. And each downward movement causes his portfolio value to fall but his expectation of long-term returns to rise. Investors who are indifferent to the direction of short-term price changes are investors who truly are able to focus on the long term.
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Or at least so says I!
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