Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on December 19, 2010. Wade sent his response the following day.
Wade said: “‘I’m excited about this, as depending on what you have already done, I think I can design a study using the Shiller data to provide historical simulations of VII strategies against fixed buy-and-hold strategies and also lifecycle strategies (declining allocation to stocks as one ages). If VII consistently outperforms fixed and lifecycle strategies, then the proof is in the pudding so to speak. Given how well valuations help to explain withdrawal rates, I think there is a lot of potential for this topic.”
He added that Monte Carlo simulations do not work in this area because “the assumptions built into their design will mean that valuations do not matter by definition.” He argued that this type of study can only be done with historical data and speculated that using Monte Carlo simulations may have thrown some researchers off the right track.
Wade also suggested that different types of investors might want to follow different allocation-change rules. “There are lots of possibilities,” he said.
My response is set forth below.
Wade:
All that sounds super.
You may want to take a look at the analysis/graphics set forth at this link:
http://www.financialwebring.org/forum/viewtopic.php?t=106998
This examination of how Valuation-Informed Indexing has performed historically was done by Norbert Schenkler, a part-time financial planner and co-owner of the Financial WebRing Forum. He is a long-time abusive poster at numerous boards but it appears to me that he was playing it straight in preparation of this analysis.
He says: “The evidence is pretty incontrovertible. Valuation-Informed Indexing is…everywhere superior to Buy-and-Hold over ten-year periods.” The one exception he finds is the late 1990s. But that is no longer an exception since the crash
(the analysis was prepared pre-crash).
John and I prepared a calculator called “The Investor’s Scenario Surfer” that permits a Monte Carlo testing of possible 30-year return sequences so that investors can compare how they would have done with VII vs. how they would have done with 80 percent reebalancing, 50 percent rebalancing and 20 percent rebalancing:
http://www.passionsaving.com/portfolio-allocation.html
The Monto Carlo used here is a bit different from what is usually used in that it contains filters that cause the results to show a valuations effect (going-forward returns are higher starting from low-valuation starting points).
I am not advocating either Monte Carlo or actual historical data. Some view the actual data as more real. But some others argue that 140 years of data is not enough to draw definitive conclusions. I personally like the filtered Monte Carlo approach. But it makes sense only for those who already buy into the idea that valuations affect long-term returns, so I think it could be argued that in a sense it begs the question. My aim here is just to let you know about what I know that has already been done so that you can review if before choosing your own path.
My experience with the Surfer is that VII produces the best 30-year results in about 90 percent of the return sequences generated. 80 percent rebalancing almost always places second, 50 percent almost always places third, and 20 percent rebalancing almost always places last.
There’s a pattern that applies in most runs that explains why VII usually ends up ahead. It sometimes takes only a few years for VII to go ahead and it sometimes takes many years. But this almost always happens at some point in a 30-year cycle (in every 30-year cycle in the real world, we have had one occasion when valuations were dangerous). Once VII goes ahead, it becomes impossible for 80 percent rebalancing to catch up because VII and Buy-and-Hold both call for high stock allocations at moderate and low valuations. And the compounding effect causes VII to go farther and farther ahead over time.
The thing that make the difference as to whether VII wins by a little or a lot is how early in the 30-year cycle it goes ahead. The dynamic here is that it is virtually a lock that sometime within a 30-year period valuations are going to become a big factor. And one big win due to valuations makes a huge difference at the end of 30 years after compounding is taken into effect. The numbers are counter-intuitive (as is always the case with compounding) and very impressive.
I STRONGLY agree with your point that there is more than one possible VII approach. This one is a little bit of a pet peeve of mine. People often ask me “What is the best allocation at today’s P/E10 level?” There is no one answer. Asking that question is like asking John Bogle “What is the one stock allocation that everyone should go with?” VII is different than Buy-and-Hold in that it posits that an investor must not go with the same allocation at all times. But it does not posit that
valuations are the only factor. So the investor still needs to take his financial goals, his age, and his risk tolerance into consideration.
RobCast #137 is titled “Nine VII Portfolio Allocation Strategies”:
http://www.passionsaving.com/personal-finance-podcasts-page-eighteen.html
Sorry to dump even more material on you. Please just look at what you think might be of use when you get a chance to do so. You will learn that expressing even limited interest in any of this stuff when I am in the room can be dangerous!
Rob
A lot of good things in this blog entry.
In former posts, I observed there were at least several buy and hold strategies I thought worked well, over the past 40 years. Those strategies were what can be termed “conservative” approaches, at least 60% using Intermediate Treasuries for conventional portfolios (the Harry Browne approach being a whole ‘nother thing). To be sure, they did damned well across this time, and with few and low drawdowns.
40 years is a long time but it isn’t the most important time—going forward is. After pondering this, I realized that my conservative approach (the one laden with Treasuries) worked mainly because of the “bond Bull” which lasted this long; not surprisingly, HB uses 50% Treasuries also, with a maturity averaging 15 years, so you can see where that helped enormously. And that was then.
Point is , given current bond yields (all time lows) the next 40 years are not likely to resemble the back 40, even if Treasuries will have a comparatively favorable correlation with equities. And “fighting the last war” has never been a good idea—in any field. This can be the trouble with many backtested inferences.
I’m certainly not saying that stocks will be the kings going forward, especially from current valuations. So folks should not seek shelter there—even in dividend champions—as some experts proclaim. And I’m not saying to avoid bonds. And the HB portfolio may continue to outperform conventional buy and hold portfolios.
I am saying that I have an even greater appreciation for the dominant power of valuations than I did in 2007, especially in stocks but in fixed income too.
And there are as many implementations of valuation-informed investing as there are personalities. Personal taste for risk will play here just as surely as it does anywhere else.
Price matters: The governing dynamic appears to be a reduction in equities—from some personal baseline—when equity valuations run high and an increase when they fall low. But one must find one’s own path to that. Likely this takes experience, and time-in, just like anything else.
It isn’t a formula. It is a concept. And such is a dynamic thing when dealing with humans.
It isn’t a formula. It is a concept.
Yes. Bless you for saying that, Arty.
People ask me over and over and over again to supply the formula. And there just can never be a formula. The Buy-and-Holders don’t have a formula that they use to tell everyone what their stock allocation should be. So why is there this thought that the Valuation-Informed Indexers should have such a thing?
The ONLY difference between BH and VII is that VIIers consider price when making stock purchases. That’s it. It’s very, very, very, very simple.
But it is also very, very, very, very far-reaching in its implications.
No market can function when those participating in it do not consider price. When price is ignored (that is, when market participants become Buy-and-Holders), the market becomes dysfunctional. It is because of Buy-and-Hold that we had a stock crash. it is because of Buy-and-Hold that we are in an economic crisis. It is because of Buy-and-Hold that the middle-class is in the process of being wiped out and we are seeing millions of people lose confidence in our political system.
The good news is that it would be so easy to fix all these problems. Just open the internet to honest posting on stock investing and all the magic happens!
The bad news is that the Buy-and-Holders very, very, very, very much do not want to acknowledge that they didn’t know it all when they developed THEIR concept. The full reality is that it would be unreasonable to have expected them to know it all — the research needed to know it all had not yet been published at the time!
Still, they do not want to acknowledge the innocent mistake they made. So we are all suffering together instead of learning together.
Yak!
Rob
You might want to take a look at the three-part series on these questions finished today by one of my fellow bloggers, Arty:
http://dqydj.net/what-kind-of-investor-are-you/
http://dqydj.net/the-efficient-market-hypothesis-is-flawed/
http://dqydj.net/if-buy-and-hold-doesnt-work-then-what/
Good stuff.
Rob
I was one of those who asked you about implementations early on. It is a good question. I thought you gave good answers, given there is no one correct answer. It took me lots of work to come to my present understanding. It is reasonable to expect it should take time-in (battle experience) and research for others too.
My present approach would require infrequent (but sizable) allocation shifts; I’d be holding quite a bit in my “baseline” band.
There is some irony in this, as it seems that not even yearly rebalancing is required—just the occasional allocation shifts. Thus, I may even be trading less frequently than many buy, hold, and rebalance guys.
So what does Wade think of you recounting the details of his emails on your blog? And what is the point in doing so? These emails are nearly ancient.
It is a good question.
People obviously need to know how to implement the strategy. I of course understand the need for that.
But asking how to practice Valuation-Informed Indexing is like asking “how do you play baseball?” You could spend many years examining this sort of question.
People can offer their ideas re implementation. But there will never be one person who will be able to supply all the answers. We will still be discussing the implementation of VII hundreds of years from now.
Rob
it seems that not even yearly rebalancing is required—just the occasional allocation shifts.
Certainly not. One allocation shift every 10 years or so on average will do the trick.
I may even be trading less frequently than many buy, hold, and rebalance guys.
Absolutely. That’s what I would expect to be the case.
Buy-and-Hold is a purely emotional strategy. So people experience freak-outs when they realize they are in the process of losing all their money. Valuation-Informed Indexers know their return (not precisely, but well enough) before they put money down on the table. So they never feel those awful feelings of anxiety that are characteristic of the Buy-and-Hold approach.
Rob
So what does Wade think of you recounting the details of his emails on your blog?
Wade is not happy with me at the moment, Diversified.
His last e-mail to me (after I told him that I would be reporting on our e-mail correspondence) was cold and hostile in tone. He has worked out some sort of “deal” with the L-Heads and the G-Goons and he is concerned that I am making him look bad by reporting what he honestly believes about how stock investing works.
I of course see it just the other way. It is the L-Heads and the G-Goons who are destroying his reputation by insisting that he not post honestly. I have told Wade many times to have nothing whatsoever to do with such people (with the possible exception of speaking out against them and urging a lifting of the Ban on Honest Posting that they have insisted be imposed at all of our boards and blogs).
It breaks my heart! I love the man and I love the man’s research.
This is not an easy job!
Rob
And what is the point in doing so?
Have you read any of the e-mails, Diversified? For heaven’s sake!
Look at today’s. Wade is one of the top researchers in the field (I put him at #1 today, even ahead of Shiller). And look what he says in this e-mail. He says that Valuation-Informed Indexing works. He says “the proof is in the pudding.” Indeed!
Discussion of Valuation-Informed Indexing is banned at 15 investing boards and blogs. Why? Because the academic research has been showing for 30 years now that Buy-and-Hold is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind. Permitting honest posting on what works makes those who have been covering up the dangers of Buy-and-Hold for 30 years now look just awful.
This is the biggest economic and political story of our lifetimes, Diversified. You thought Watergate was a big story? Watergate didn’t cause an economic crisis. Watergate didn’t cause millions of middle-class people to suffer failed retirements. Watergate didn’t block millions of people from learning about investment research that would permit them to reduce the risk of stock investing by 80 percent and to retire five to ten years sooner than was previously possible.
There’s no comparison between Watergate and The Great Safe Withdrawal Rate Debate. We’ve got a tiger by the tale re this one. I’m sure of it!
Rob
Wade appears to be posting quite openly and honestly about safe withdrawal rates. I regularly read his blog.
The fact that you think buy and hold caused the latest economic crisis is one your most spectacular delusions in what is surely a long list of delusions. Have you read single article on the financial crisis? A single book?
Also, you continually use the plural personal pronoun. As best I can tell, you are a lonely voice of one. You seem to have a need to quickly antagonize anyone you come in contact with.
Wade appears to be posting quite openly and honestly about safe withdrawal rates.
Did you happen to see the comment he put to this blog at which he expressed the view that there is no pressing need for Bill Bengen to correct his Safe Withdrawal Rate Study (Bill’s study is an Old School SWR study)?
Rob
As best I can tell, you are a lonely voice of one. You seem to have a need to quickly antagonize anyone you come in contact with.
Good point, Diversified.
I’ll continue to post honestly re safe withdrawal rates and other critically important investment-related topics all the same. Call me wacko!
Rob
You are wacko, but not for the reasons you think.
Have fun storming those windmills!
Fair enough, my old friend.
Rob