Set forth below is the text of a comment that I recently put to another blog entry at this site:
Roger Wohlner at the The Chicago Financial Planner blog: Interesting. One one question is this: Does anyone actually run a real portfolio based on this and if so what are the real results. By real results I mean real vs. back-tested. I’m not disputing what you are saying but the bottom line to me and I think to any investor is how has this done in the real-time world. Thanks.
Here is the peer-reviewed research co-authored by Wade Pfau and myself that shows that Valuation-Informed Indexing has been far, far superior (providing far higher returns at greatly reduced risk) to Buy-and-Hold for the entire 140 years for which we have historical data available to us:
You seem to be suggesting that research that looks at the entire historical record is “backtesting.” In this case, that is not so. Shiller put forward the first paper on the basic concept in 1981. That’s over 30 years ago. We now have 32 years of REAL TIME CONFIRMATION that this is what really works. In those 32 years, the market has continued to perform how it always performed in the past (as reported by Shiller in 1981) and NOT in accord with how the Buy-and-Hold Model posits that it should perform.
I can give some examples of how this concept has been applied in a forward-looking way.
I put my first post to the Motley Fool board on May 13, 2002. I said that, given what we know about how valuations affect long-term returns, the Old School safe withdrawal rate studies must have the numbers wrong (those studies do not adjust for the valuation level that applies on the day the retirement begins). One of the first questions I was asked by my Buy-and-Hold critics was: “Well, if our SWR calculations are wrong, what is the true SWR?” I didn’t know. I had never done a calculation. Logic told me that the existing calculations had to be wrong but logic did not tell me what the right number was.
I was putting my reputation on the line there. People were obviously going to look into this deeper than I had up to that point. I was going to be proven right or wrong. Not in a back-tested way. In a real-time, going-forward way.
I was proven right. John Walter Russell ran the numbers and found that the true SWR at the top of the bubble was 1.6 percent. Nothing even remotely in the same neighborhood as 4.0. And about ten years later, every major publication in this field had run articles reporting that the Old School SWR studies got the numbers wildly wrong. There have been articles in the Wall Street Journal, the Economist, Smart Money, Reuters, and on and on and on. How did I know that 10 years earlier than the biggest-name experts in the field?
Another case is when Shiller wrote the following words in his book (which was published in March 2000):
“Individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”
How did Shiller know in March 2000 what was going to happen in September 2008? He knew because he knows how stock investing really works. The word “overvalued” means just what it suggests. It means that stocks are mispriced. And the entire purpose of a market is to get prices right. So mispricings are always corrected over the course of 10 years or so. When there are massive mispricings, there are massive corrections. Those corrections are called “recessions,” or, in extreme cases, “Great Depressions.” We are living through one of the extreme-case massive corrections today.
I’ll point you to a third case, this one involving the King of Buy-and-Hold, Jack Bogle. I recorded a RobCast on this one, RobCast #41, “Bogle and Valuations.”
Bogle said in the wake of the 2008 crash that stocks were at the time priced at $9 trillion less than they had been previously priced. He pointed out that it is absurd to believe that the U.S. economy lost $9 trillion of real value in a few months of time. He is of course correct about this.
So what happened?
If the Buy-and-Hold Model is valid, stock prices accurately reflect economic values. But the #1 advocate of Buy-and-Hold in the world says that they do not. Huh?
If Shiller is right, stock prices in the short term reflect not economic values but investor emotion. Investor emotion can of course swing wildly without any rational cause. So the loss of $9 trillion in value that we saw in 2008 entirely fits the Valuation-Informed Indexing model but not at all the Buy-and-Hold Model. Again, this was not backtesting. None of us Valuation-Informed Indexers knew in advance that Bogle was going to make such a statement and then developed our model to fit that statement. We described first how the model works and then Bogle (someone with zero reason to want to slant things in our direction) made a statement confirming the reality of our model.
May I direct your question back at you?
Is there any backtested support for the Buy-and-Hold Model?
There is not.
Buy-and-Hold became popular with the 1974 publication of “A Random Walk Down Wall Street.” Many people became convinced by the results they saw following that date that Buy-and-Hold works. But stocks were priced at insanely low levels in 1974. Valuation-Informed Indexers say that stocks MUST provide insanely good results starting from such price levels. So the results we saw from 1974 through 1995 are 100 percent in accord with what a Valuation-Informed Indexer would expect and predict.
From 2000 forward, stock results have been poor. Stocks were overpriced throughout that time-period. So those results are again 100 percent in accord with what Valuation-Informed Indexing says we should see.
There are four years in which Buy-and-Hold paid off big time — 1996 through 1999. Those were amazing years for Buy-and-Holders, I certainly give you that. But the question is — Are those returns permanent? The Valuation-Informed Indexing model posits that stocks are priced today for a 65 percent drop sometime over the next few years (there has never yet in history been a single time when we had a massive bull market and not ended up at a P/E10 level of 8 or lower). If we see a 65 percent price drop, no one is going to say that Buy-and-Hold works.
I have 140 years of historical data that supports Valuation-Informed Indexing. But the Buy-and-Holders say that that is not enough for me to be permitted to post on any internet discussion board or blog. But it is not possible for me to have MORE than 140 years of support. There are only 140 years of data available to us.
You are suggesting that only backtested years count. But Buy-and-Hold has never been backtested! Buy-and-Hold started in 1974 and we are still in the same Bull/Bear cycle that was getting started then. So we do not know how Buy-and-Hold will end up performing in the first forward-facing test it has ever been put to. It could be that, by the time this first test is complete, there won’t be one human being with a good word to say about Buy-and-Hold.
I don’t say that I am God, Roger. I have zero problem with the idea of adding words to every post I advance saying “this fellow has been wrong about a lot of important things over the course of his life and it is entirely possibly that it is happening again.”
Do you think my Buy-and-Hold critics would be okay with adding the same words to THEIR posts?
Are Buy-and-Holders fallible?
If they are fallible and if they made a mistake in this case, how is it that they will ever discover this?
Will it take a Second Great Depression?
My view is that we are all fallible and that we all should acknowledge it and show respect and affection to those of our friends who make an effort to show us where we might have gotten something wrong. It is that belief that is reflected in the published rules of every board and blog I have ever visited. It is my belief that every single one of us, Buy-and-Holders and Valuation-Informed Indexers alike, should want to see those published rules honored both in act and in spirit.
I have learned a great deal from my many Buy-and-Hold friends. I think that I have something important to teach them in return. I would like to have the opportunity to pay back that intellectual debt.
I am grateful for your willingness to engage in a little back-and-forth discussion here.