Academic Researcher Wade Pfau: “Though I Was Only Trying to Do an Old-School Safe Withdrawal Rate Study, All That I Ended Up Doing Was Showing in a Different Way What You Had Been Saying All Along — The SWR Changes With Valuations”

Yesterday’s blog entry reported on an e-mail sent to me by academic researcher Wade Pfau on February 22, 2011. On February 15, 2011, I received an e-mail from Wade on a different topic, his research on safe savings rates.

He said: “You and DRiP Guy realized immediately about my new paper what it took me a few days to come to grips with: though I was only trying to do an old-school SWR study, all that I ended up doing was showing in a different way what you had been saying all along: the SWR changes with valuations.  I guess I’m cursed by valuations now 🙂 I hope my paper can help that idea get acceptance, since I don’t really mention valuations in it, but once people get warmed up to the idea, they will realize, as I did, that valuations are the driving factor.  But perhaps it is better for people to realize that for themselves, rather than to point it out to them directly.”

I sent my response the following day. Here is the text:

Wade:

We are ALL cursed by valuations!

My true belief is that we are all BLESSED what we have learned about valuations. Unfortunately, for the moment it FEELS like a curse.

It’s possible that coming at the valuations question from an indirect angle might help you slip through the radar. I wouldn’t bet big money on it. But there’s certainly no harm in trying something new. And in any event I think that looking at things in this way highlights some new points. So I very much see this as being a highly positive thing.

I agree to a point with your statement that “the biggest risk of VII is that a prolonged boom leaves you sitting on the sidelines too long.” It doesn’t do this if it is followed in a reasonable way. But if someone overacts, this is indeed a serious risk. The answer here is not to avoid discussing the strategy. The answer is to discuss it with enough care so that people come to understand how it works.

There are two competing realities. One reality is that stocks are generally the best asset class. Anytime you lower your stock allocation, you are going against that reality. So it would be fair to say that you better have a good reason for going against that reality.

The other reality is that the riskiness of stocks increases with increases in valuations. This is ALSO an important reality. It’s not the only reality but it is not a reality that may safely be ignored.

The trick is to keep BOTH realities in mind when making stock allocation choices. It cannot be done right any other way. It is unbalanced to consider either of the realities in isolation.

I think this can be compared to raising kids. We all know parents who set zero boundaries and whose kids suffer as a result. And we all know parents who come down too hard and whose kids suffer as a result. We just have to accept that it is possible to come down too hard and that it is possible to come down not hard enough and to try to avoid the extremes.

So it is with considering valuations when setting one’s stock allocation. It is possible to give valuations too much consideration and it is possible to give valuations too little consideration.

What people are missing is how EXTREME Buy-and-Hold is. Buy-and-Hold takes the most extreme position possible (don’t adjust for valuations at all!) and puts it forward as the norm. Nothing could be more irresponsible, in my view. We should all be giving people all the help we can supply re balancing the competing considerations. No one should be arguing the merit of one side of the story being the only one that can be heard.

Rob