Set forth below is the text of a comment that I recently put to a thread at the The Good Phight site, a site on the Phillies baseball team:
This is my life. I am happy to respond to any and all questions so long as the overall community continues to feel that that is a good thing to do.
Here is the paper:
It’s all worth checking out. But it is Table One on Page 18 that absolutely blows my mind. Wade compares the Maximum Drawdown Percentage for Valuation-Informed Indexing and for Buy-and-Hold. The Maximum Drawdown is the greatest percentage loss in portfolio value that you will ever experience. For Buy-and-Holders, it is 60 percent. For Valuation-Informed Indexers, it is 20 percent. You reduce risk by two-thirds by being willing to take price into consideration when setting your stock allocation. Exercising price discipline pays off big time in the long run! Please understand that you do not give up anything in the return department to obtain this huge reduction in risk. In fact, you can play it the other way. By taking on the same amount of risk as Buy-and-Holders, Valuation-Informed Indexers can obtain far higher long-term returns. Or you can mix and match return and risk and do a bit better in both departments.
The biggest problem that people have with this is in trying to understand why everyone in the field isn’t talking about it. To get that, you have to be familiar with the history.
Stock investing generally was not the subject of sustained and systematic study until the 1960s. In 1965, University of Chicago Economics Professor Eugene Fama produced the breakthrough finding that is the basis for 90 percent of the investing advice you hear cited by experts today. Fama showed that “timing never works.”
Actually, he did NOT show that. That’s what he had THOUGHT that he had shown. He was a bit off the mark in his understanding of what he had done.
There are two forms of market timing, short-term timing and long-term timing. Short-term timing is when you change your stock allocation because of a belief as to where prices are headed over the next year or two. Long-term timing is when you change your stock allocation because of a big shift in valuations with the understanding that you may not see benefits for doing so for as long as 10 years.
Long-term timing is price discipline. Price discipline is the magic that makes all markets work. So it is not possible that long-term timing would not work. But long-term timing was not a practically viable strategy in 1965. Long-term timing works only with broad index funds, which did not become widely available until John Bogle founded Vanguard in 1974. So Fama did not even bother examining long-term timing. He looked only at short-term timing, found that it didn’t work and then improperly stated his finding as a finding that timing in general does not work.
Yale Economics Professor Robert Shiller was the first academic to examine long-term timing. He found in 1981 that long-term timing always works and is always 100 percent required for investors who hope to have any realistic chance of long-term investing success. There have been many re-examinations of this question in the 33 years since and all have confirmed Shiller’s finding that long-term timing always works. The other side of the story is that there has never been a single study showing that long-term timing might not work. Wade researched this question very carefully. He was so amazed by his finding that he went to the Bogleheads Forum to check whether anyone there was aware of a single study showing that long-term timing might not work. Some of the biggest-name Buy-and-Holders post there, including John Bogle himself. Neither Bogle nor any of the others had ever heard of a single study suggesting that long-term timing might not work.
Shiller’s 1981 finding was revolutionary. It changes everything that we once thought we knew about how stock investing works. As noted in the study linked above, it suggests that stocks need not be a risky asset class. For those who take valuations into consideration, risk pretty much disappears. Stock investing risk is VOLUNTARY.
It also suggests that risk is VARIABLE rather than constant. I am the person who discovered the errors in the retirement studies that millions of people have used to plan their retirements. These studies are called “safe withdrawal rate” studies. Every major publication has published an article on the errors in these studies in recent years, including the Wall Street Journal., The error was that they do not contain an adjustment for the valuation level that applies on the day the retirement begins. That’s not an error if Fama is right. It is a HUGE error if Shiller is right. The Old School studies reported that a 4 percent withdrawal is always safe (that means that a retiree with a $1 million portfolio can take $40,000 out to live on each year). The New School SWR studies (there’s only one, which was done by me and John Walter Russell) show that the SWR varies from 1.6 percent when stocks are priced as they were in 2000 to 9 percent when stocks are priced as they were in 1982. For a retiree with a $1 million portfolio, that’s the difference between living on $16,000 every year in retirement and living on $90,000 every year in retirement. If Shiller is right, we will be seeing millions of failed retirements because of our failure to demand corrections in the Old School SWR studies for so many years (I put up the post pointing out the errors to a Motley Fool discussion board in May 2002 and none of the studies have been corrected to this day, despite the Wall Street Journal article and articles published in many other big-name publications).
The biggest implication of Shiller’s work of all is that it is the promotion of Buy-and-Hold strategies that caused the economic crisis. If Fama is right, the concepts of overvaluation and undervaluation are exercises in silliness. An efficient market is a properly priced market. There can be no overvaluation if Fama is right. But if Shiller is right, we know that market prices always move in the direction of fair value in the long term. By calculating the dollar amount of overvaluation, we can know how much consumer buying power will be leaving the market as prices make their slow way back to fair value. The market was overpriced by $12 trillion in 2000. Shiller predicted in March 2000 an economic crisis that would hit by the end of he decade in which we might experience the loss of monetary value equal to the monetary value of all houses in the country. The economic crisis hit in September 2008. No economy is so strong that it can take a loss of $12 trillion in spending power and not collapse.
There have been four economic crises since 1870. Each followed a time when the P/E10 value (Shiller’s valuation metric) exceeded 25. There has never been an economic crisis in which the P/E10 value did not exceed 25. The correlation is perfect (although imprecise — we CANNOT say when a price crash or an economic crisis will come, only that one will come once we exceed a P/E10 value of 25). When large numbers of investors become persuaded to follow Buy-and-Hold strategies, there is no other way for the market to perform its essential function of setting prices properly EXCEPT by crashing. In all markets other than the stock market, it is the tension between the seller’s interest in a high price and the buyer’s interest in a low price that permits the market to set the price at a roughly right level. In a market in which a large number of investors are following Buy-and-Hold strategies, everyone is rooting for the same thing — a high price. There is no price discipline when investors are not willing to lower their stock allocations when prices get too high and when the long-term value proposition for buying stocks drops too low.. Such markets inevitably crash and the loss of consumer buying power resulting from the crash causes hundreds of thousands of businesses to fail and millions of workers to lose their jobs.
These are revolutionary advances in our understanding of how stock investing works. They were too much for most of the experts to take in when Shiller published his 1981 findings. The result was a widespread case of cognitive dissonance. Everyone acknowledges that Shiller did amazing work. He was awarded the Nobel Prize in Economics last year. But no one can point to a single change in the investing advice they give that was made as a result of Shiller’s findings. Shiller’s book was a bestseller and was reviewed in all the top publications. But he devotes only a few vague paragraphs to the question that everyone cares most about — how should investors change how they invest their money as a result of his revolutionary findings? This question is The Third Rail of Personal Finance — those who touch it experience career death. In fact, a number of Buy-and-Holders threatened to send defamatory e-mails to Wade’s employer in an effort to get him fired from his job when he showed up at the Bogleheads Forum and a number of community members there expressed great interest in our research. Wade agreed to stop telling people about our research findings.
I have spoken to many academics and practitioners about this stuff. Many have told me that they would LOVE to feel free to tell people about the implications of Shiller’s work but feel that the topic is too controversial today. I believe that interest in this research is going to explode following the next price crash. I saw a big change in public receptiveness to the new research following the 2008 crash. I would say that that crash pushed the door about one-third open. I believe that the next crash (which should come by the end of 2016 according to Shiller’s research) will push the door open the rest of the way.
The bottom line here is that we need to combine Fama’s finding that short-term timing never works with Shiller’s finding that long-term timing is always required to have an investing strategy that truly makes sense and that is truly research-backed. That strategy is Valuation-Informed Indexing, which is the same as Buy-and-Hold in all respects except that Valuation-Informed Indexers ALWAYS adjust their stock allocations in response to big price swings with the aim of keeping their risk profiles roughly constant over time. We need to quantify the long-term effects of valuation shifts and provide tools to investors showing them how much they hurt their hopes for achieving decent retirements by refusing to consider price when buying stocks.