"Retirees Now Frequently Base Their Retirement Decisions on the Portfolio Success Rates Found in Research Such as the Trinity Study.... This Is Not the Information They Need for Making Their Withdrawal Rate Decisions."
"Big Moves Out of Stocks Should Not Be Done at All. But Strategic Asset Allocation Can Be Done At Very Rare Times, Maybe Six Times in an Investor’s Lifetime, Three Times When the Market Is Stupidly High and Three Times When Stupidly Low."
"There Is An Extensive Literature About the Predictability of Long-Term Stock Returns. There Is an Extensive Literature About Short-Term Market Timing. My Question Is About Long-Term Market Timing. The Literature Seems Slim."
"For Years, the Investment Industry Has Tried to Scare Clients Into Staying Fully Invested in the Stock Market at All Times, No Matter How High Stocks Go. It's Hooey. They're Leaving Out More Than Half the Story."
"There Are Time-Periods Where Stocks Are a Terrible Addition to That Portfolio. Yet Inexplicably, We As Planners STILL tend to Suggest That It Is 'Risky' to Not Own Stocks When in Reality the Only Risk Is to Our Business."
"There Is a Growing Behavioral Economics Movement, But It So Far Has Had Limited Impact. Economists Are Not Fond of the Softness and Imprecision of Psychology. These Notions Are Considered Vaguely Unprofessional and Flaky."
"I Was Hooked on the Idea of [Passive] Index Indexing, But Something Inside Made Me Wonder "Too Good to Be True?" and "What's the Downside?" I Happened on to Your Site and Valuation-Informed Indexing Seems to Make Sense."
"Rob's Da Man! Never in the History of the Diehards Forum Has One Poster, Always Making Civil and Well Thought-Out Posts, Managed to Irritate So Many Without Anyone Being Able to Articulate a Good Reason As to Why."
"Rob Bennett: Some People Disagree With Him, and He Rubs a Lot of People the Wrong Way. But He Has Interesting Ideas About Valuation-Informed Indexing, and He Delves Into a Lot of What Makes a Successful Investing Strategy."
"The Return Predictor Is Based upon the Principle that Over the Long Term, Stock Market Prices Will Reflect the Ten-Years Earnings Growth of the Underlying Companies. Prices Return to a Common Growth Pattern."
"You Go About It in a Manner that is Catastrophically Unproductive by Adding Missionary Zeal that Inflates Your Importance and Demeans Others. The Whole Idea That There is a New School of Safe Withdrawal Rates Reeks of Personal Aggrandizement."
“What Warren Buffett Did Was Essentially Quite Close to What Rob Bennett Has Written. Buffett Has in Fact Been Cleverly Incorporating Long-Term Market Timing Based on Valuation of the Market in His Allocation of Money to Stocks.”
"You've Got to Say One Thing for Rob. He Has NEVER Lowered Himself to Ad Hominen Attacks -- Subliminal or Otherwise -- on Any Other Person on This Board. Not Once. Ever. At Least Give Him Credit for That."
"Mr. Bennett, You Are Spot on About Integrating Some Type of Valuation Filter to One's Stock Allocation. Astute Investors Have Incorporated Some Type of 'Valuation Timing' Into Their Investment Decisions Since the Beginning of Time."
"There Is Nothing More Doubtful of Success Than a New System. The Initiator Has the Enmity of All Who Profit By Preservation of the Old Institution and Merely Lukewarm Defenders in Those Who Gain By the New One."
"Difficult Subjects Can Be Explained to the Most Slow-Witted Man If He Has Not Formed Any Idea of Them. But the Simplest Thing Cannot Be Made Clear to the Most Intelligent Man If He Believes He Knows Already What Is Laid Before Him."
"I Certainly Have Seen the Academic Profession Squelching Unfashionable ideas and Have Often Been on the Wrong Side of It. Kuhn Shows How Most Pathbreaking Scientific Ideas Are Rejected at First, Usually for Decades.”
"Rob Bennett Was an Early Pioneer in 3rd Generation Modeling by Advocating (Through Various Online Forums) that Withdrawal Rates Must Be Adjusted for Market Valuations Consistent with Research by Campbell and Shiller."
"I Am Fascinated by the Growing Body of Research that Revolves Around the P/E10 Ratio by Robert Shiller, Doug Short, Wade Pfau, Michael Kitces, John Hussman, Crestmont Research, Jim Otar, Mike Philbrick, Adam Butler & Rob Bennett."
"Rob Is an Enigma in the Personal Finance World. He Has Interesting Theories on Investing Based on Market Valuations. But He Weaves a Tale Which Makes the Stories of Alexander Litvinenko & Gareth Williams Seem Tame by Comparison."
"I Have Read Everything I Can About Valuation-Informed Indexing. Buy-and-Hold Is Extremely Problematic. I Respect the Passion, Hard Work and Research That You Have Put Into This Very Important Issue. Your Work Has Huge Value."
"The Amount of Return You Can Expect From a Diversified Equity Portfolio Is Inversely Correlated to the Market Valuation at the Start of the Holding Period. It Is One of the Most Robust Statistical Relationships in Modern Finance."
"I've Had Similar Experiences. I Know of Two Young Professors Who Wanted to Do Research on Fundamental Index and Reported to Me That Their Colleagues Advised Them That This Line of Research Could Derail Their Career Prospects."
"As with Drug Studies Funded by Drug Companies, It Would Be Churlish to Suppose that the Chicago School of Business Was in the Bag. But It Would Also Be Idealistic to Assume That There Was No Funding Bias at All."
"This Sort of Intimidation Is Not Acceptable. The Cigarette and Pharmaceutical Industries Found Research Supporting Their Products By Funding It. But That Was Big Money Supporting Outcomes, Not Dissuading Others."
"The Situation [Referring to the Intimidation Tactics Used to Silence Academic Researcher Wade Pfau's Reporting of the Dangers of Buy-and-Hold Investing Strategies] Seems Well Below Any Professional and Academic Acceptable Standards."
"It Is Obvious that Rob, in Attempting to Identify New Safe Withdrawal Rate Strategies...Is Goring Your Ox. If Rob Improves on [the] Safe Withdrawal Rate Methodology, the Implication Is Clear: You Are All, Metaphorically, Out of Business."
"Naturally, I Am Finding That Valuation-Informed Indexing Can Allow You to Reach a Wealth Target With a Lower Saving Rate and to Use a Higher Withdrawal Rate in Retirement Than You Could With a Fixed Allocation."
"A Careful Examination of Past Returns Can Establish Some Probabilities About the Prospective Parameters of Return, Offering Intelligent Investors a Basis for Rational Expectations About Future Returns."
"How Can It Be That One-Year Returns Are So Apparantly Random and Yet Ten-Year Returns Are Mostly Forecastable? In Looking at One-Year Returns, One Sees a Lot of Noise. But Over Longer Time Intervals the Noise Effectively Averages Out and Is Less Important."
"The Notion That Rich Valuations Will Not Be Followed By Sub-Par Long-Term Returns Is a Speculative Idea That Runs Counter to All Historical Evidence. It Is an Iron Law of Finance That Valuations Drive Long-Term Returns."
"It's January and the Temperature Is Below Freezing. If You Asked Me Whether It Will be Warmer or Cooler Next Tuesday, I Would Be Unable to Say. However, If You Asked Me What Temperature to Expect on April 9, I Could Predict "Warmer Than Today" and Almost Surely Be Right."
"If the Response Is "Who Knew?", It Won't Be Much Comfort for Retirees in the Employment Line at Wal-Mart. This is Especially True Since a Rational Understanding of History and the Drivers of Longer-Term Stock Returns Can Help Retirees To Avoid That Surprise."
"New of the Demise of the Random Walk Has Only Very Slowly Spread, In Part Because Its Overthrow Came as a Shock. If the Random Walk Hypothesis Were Correct, the Most Likely Return Would Be the Historic Average Return. The Evidence, However, Is Strongly Against This."
"I Don't Care If You Do or Don't Believe That the Market Will Behave Similarly in the Future As It Has in the Past. Either Way, This [The Stock-Return Predictor] Is an Excellent Way to Understand What the Market Has Done In the Past."
"It Really Is a Shame and Indefensible That So Many Feel the Need to Jump Into It With No Interest of Posting on the Topic But Just to Disrupt. Are You That Insecure? Some on the Forum Have an Interest in This Topic. If You Don't, Stay Out!"
"Irrational Behavior Does Follow Patterns. But How Many Experts in Behavioral Finance Believe That Such Knowledge Can Be Used to Predict Markets? Basically, None. Your Model Cannot Attain the Level of Predictive Value You Claim."
"The Safe Withdrawal Rate Studies Are Based on History. This [The Retirement Risk Evaluator] Shows, Based on the Same History, What the Probabilities Are for the Future at Various Starting Points. If the First Has Value, Then Surely This Does Too."
"There Are Hundreds of People Who Contributed to This. This Calculator [The Stock-Return Predictor] Demonstrates in a Compelling Way the Power of This New Internet Discussion-Board Communications Medium."
"A P/E10 of'26' Is Bad. Now Look at the 30-Year Return Predicted by the Calculator -- 5.4 Percent Real. That's Not Bad. There Are All Sorts of Strategic Implications That Follow From Understanding That Stocks Provide Different Sorts of Returns Over Different Sorts of Time-Periods."
"I Would Never Invest in Anything Without Having Any Idea What the Expected Return Is. For Instance, I Would Not Walk Into a Bank And Say "I'll Take One Certificate of Deposit, Please" WIthout Asking What Rate They Are Offering."
"I've Seen Things Said on Investing Boards That I Have Never Heard Said in Discussions of Any Non-Investing Topic. The Question of Whether Valuations Affect Long-Term Returns Is a Topic That Causes People More Emotional Angst Than Does Abortion or Impeachment Proceedings or the War in Iraq."
"It's Not Possible For Those Who Have Come to Believe That Stocks Are Always Best to Accept that Valuations Matter. The Two Beliefs Are Mutually Exclusive. If Valuations Matter, There Is Obviously Some Valuation Level At Which Stocks Are Not Best. The Two Paradigms Cannot Be Reconciled."
"Dear Rob -- I Just Became Aware of Your Past Research in September. Since Then, I've Read Archives From Many Discussion Boards and Websites, and I Always Find Your Writing to Be Very Interesting and Intriguing."
"I Think Rob Bennett Did Provide An Important Contribution in Terms of Describing a Way for P/E10 to Guide Asset Allocation for Long-Term Conservative Investors. I Also Think He Was Right on the Issue of Safe Withdrawal Rates."
"Because the Precise Timing of This Mean Reversion Is Not Known in Advance, Expecting the Result to Happen in the Short-Term Will Not Be Possible. But Long-Term Investors Who Can Be Patient Can Wait for This Mean Reversion and Will Eventually Come Out Ahead."
"Your Work Is at Odds with the Ethos of the Board -- Here the Theme is John Bogle's Philosophy, Which Eschews Market Timing. This Board Came Into Existence to ESCAPE One Individual, the Very Individual With Whom You Have Openly Aligned Yourself."
"Why Is It Such an Odious Violation of the Tenets of Bogleheadism to Explore Whether Someone Who Has Enough Patience Might Be Able to Benefit from the Transitory Nature of Speculative Returns (the Idea That the P/E Ratio Eventually Ends Up Where It Started)?"
"Let Me Explain Why I Posted About This Here. Valuation-Informed Indexing Has Had Critics for Years. But Until Norbert Did It In 2008, Nobody Seemed to Have Provided a Serious Investigation of It. I Couldn't Understand Why. That Bothered Me."
"If You Really Don't Like Market Timing in Any and All Forms, You May Not See Any Point in an Empirical Investigation. You View Me as One of a Long Line of Hucksters Trying to Sell You Some Snake Oil. I Don't Want to Be Such a Person."
"Having a Completely Ineleastic Demand for Equities Is a Bit Bonkers. No One Acts That Way with Life's Other Important Commodities. Campbell Advocates a Linear Valuations-Based Strategy so That You Wouldn't Be Making Big Changes. This Would Be Like Rebalancing But More Flexible."
"The Whole Idea of Valuation-Informed Indexing Belongs to You. Do You Mind if I call the Paper 'Valuation-Informed Indexing'? I Would Give You Credit. I Have Been Toying With the Idea of Sending the Paper to the Journal of Finance, Which Is the Most Prestigious Journal in Academic Finance."
"I Definitely Need to Cite You as the Founder of Valuation-Informed Indexing, As I Have Not Found Anyone Else Who Can Lay Claim to That. Shiller Pointed Out the Predictive Power of P/E10 But Never Discussed How to Incorporate It Into Asset Allocation, As Far As I Know."
"I Tested a Wide Variety of Assumptions About Asset Allocation, Valuation-Based Decision Rules, Whether the Period Is 10, 20, 30 or 40 Years, and Lump-Sum vs. Dollar-Cost Averaging To Show That the Results Are Quite Robust to Changes In Any of These Assumptions."
"I Wrote Up the Programs to Test Your Valuation-Informed Indexing Strategies Against Buy-and-Hold and I Am Quite Excited. You Say in the RobCast That VII Should Beat Buy-and-Hold About 90 Percent of the Time. I Am Getting Results That Support This."
"Never Underestimate the Power of a Dominant Academic Idea to Choke Off Competing Ideas, and Never Underestimate the Unwillingness of Academics to Change Their Views in the Face of Evidence. They Have Decades of Their Research and Academic Standing to Defend."
"Since They Did Not Diagnose the Disease, There Is Little Popular Confidence That They Know the Cure. What If Economics Is, Actually, At the Same Level as Medicine Was When Doctors Still Believed in the Application of Leeches?"
"I Love the Humans Dearly (the Title of the Book I Am Writing Is Investing for Humans: How to Get What Works on Paper to Work in Real Life) But They Can Be a Trial at Times. Hey! Helping the Humans Learn What It Takes to Invest Effectively Is Not All That Different From Being Married!
"Wow, I Did Not Realize You Had Achieved This Much Success and Had Many Devoted Believers/Followers. That’s Great, Then Ignore the Opposition. It Is Great to Have Opposition: That Means You Are Doing Something Right."
"I Do NOT Believe I Know It All. I Believe That Shiller Discovered Something Very Important and It Appalls Me That More People Are Not Exploring the Implications of His Findings. My Aim Is To Launch a National Debate."
"I LOVE Everything About Buy-and-Hold Other Than the Failure to Encourage Investors to Take Price Into Consideration When Setting Their Stock Allocations. That's a Mistake That Was Made Because Shiller’s Research Was Not Available at the Time The Strategy Was Being Developed."
"Valuation-Informed Indexing Sounds Like a Real Thing. If It Is and I Can Thoroughly Understand It, Then It Will End Up In My Classrooms and in My Students' Minds (Of Course, With References to You and Wade)."
"As a Fan of Thomas Kuhn's The Structure of Scientific Revolutions, I Know That Progress Can Be Frustratingly Slow and What Is Typically Needed Is Either a Crisis or the Ascent of a New Generation of Scientists Who Did Not Build Their Careers on the Old Models and Theories."
"We Trace the Deeper Roots [of the Financial Crisis] to the Economics' Profession's Insistence on Constructing Models That, By Design, Disregard the Key Elements Driving Outcomes in Real World Markets."
"Rob Gets Himself So Worked Up Over What Someone Else Is Doing With Their Own Money and Not Bothering Rob in the Least. As Long As They Aren't Knocking on Your Basement Door, What Do You Care? They Are Happy and Content. Leave Well Enough Alone and Focus on Your Own Account."
"I've Been on Forum Since the BBS Days and I Think Rob is Special. He Could Be an Internet Meme If He Put Some Effort Into It. Someday, He Will Realize That the Only Thing He's Good At Is Being an Epic Loser. He Just Needs to Embrace That Idea and Run With It. Watch Out, LOLCats, Here Comes Pathetic Guy!"
"You Guys [the Greaney Goons] Are the Same Jokers Who Have Done This Before, Sparring with Rob Over Nonsensical Issues On This Site and Others, Leveling Personal Attacks, and You Don't Even Use Real Names! Rob Is Entitled to His Opinion, But the Fact That You Challenge Every Jot and Tittle of What He Says Makes It Clear You Have An Unholy Agenda. Please Take It Elsehwere."
"Rob, Take This As Friendly Advice. You're a Smart and Articulate Guy and You Could Be Making Valuable Contributions to This Discussion. I've Dealt with the Mentally Ill Before and I've Found That They Sometimes Can Be Reasonable If Gently Redirected."
"I’m a Numbers Guy. And I Believe I Understand Rob’s Thesis, that Future Returns, Over the Next Decade, Have a Tight Inverse Correlation to the PE10 for the Starting Point. Remember, Correlation Doesn’t Need to be 100%, Only That There’s a Bell Curve of Potential Outcomes that Shift Meaningfully Based on the Input."
"I Have had Academic Researchers Tell Me That They Dream of the Day When They Will be Able to do Honest Research Once Again. I Have had Investment Advisors Tell me That They Dream of the Day When They Will be Able to Give Honest Investing Advice Again."
"Let’s Call a Spade a Spade, Shall We? Wade Pfau Stole Your Research and Put His Name on it, Throwing You Just a Tiny Crumb of Acknowledgement to Ward Off a Lawsuit. He’s Profiting Handsomely By His Theft, Leading a Charmed Life, Widely Published, Widely Respected. While Rob Bennett Continues to Toil in Total Obscurity. It’s So Incredibly Unfair, I Think If It Happened to Me, It Could Actually Drive Me Insane."
Juicy Excerpt #1: Could it be that the price that the market is trying to tell us is the true market price is the nominal market price as adjusted for the effect of overvaluation or undervaluation? The market generates the P/E10 figure as much as it does the nominal market price. Perhaps all the confusion over whether the market is efficient or not, and if not, why not, stems from a failure to appreciate that the market is reporting the true market price in two steps.
Juicy Excerpt #2: The suggestion here is that the only thing that has been keeping us from enjoying an efficient market is the insistence of the believers in the efficient market theory that market timing is not needed for the market to become efficient. Markets in which investors do not change their stock allocations in response to big valuation shifts cannot achieve efficiency because valuations affect long-term returns and it is irrational for investors to ignore this reality when setting their stock allocations. The market is not automatically efficient. But investors can make it efficient if they are willing to change their stock allocations in response to valuation shifts.
The blog Political Calculations has written a review of The Stock-Return Predictor. We won the “Silver Standard” designation. This is a whole big bunch better than winning the “Outright Awful” designation, assigned to online tools “that actually Make You Stupider.” I am naturally relieved.
In all seriousness, the review is an intelligent and nicely balanced write-up. I am grateful that the owner of the blog was willing to take the time to look at the calculator and to report on it to his readership.
Juicy Excerpt: “While not cutting-edge where stock market theory is concerned (that’s our bailiwick!), The Stock-Return Predictor will provide a reasonably good rule-of-thumb for informing a potential user’s stock market investing decisions. The tool provides a neat approach for delivering high quality information to the tool’s intended audience. What’s more, we really like the valuation-based approach since this helps communicate some of the risk that an investor may be taking on when making a new investment. The user-interface could use some serious refreshing, but overall, we find this tool satisfies our requirements for earning our Silver Standard. It’s informative, it’s based on solid data and it provides useful results.”
Tobin’s Q is a valuations assessment tool with a sound theoretical basis and a good track record. I view the drop in the Tobin’s Q numbers as a significant development. There are smart people who today believe that stocks are no longer terribly overvalued.
Even the P/E10 valuation assessment tool, which I prefer, reports far better numbers than those that applied a few years back. The fair-value P/E10 number is 14 or 15. At the top of the bubble, we were at 44. Today we are at 23. We are not at the price levels at which informed long-term stock investors feel comfortable going with a high stock allocation. But we have made lots of progress.
The Tobin’s Q tool and the P/E10 tool are telling somewhat different stories. It’s worth taking note of that. But I don’t view it as a big huge deal. We are still in the early stages of developing the Rational Investing approach. We still have a lot to learn. It would not be reasonable to expect all of the analytically valid valuation-assessment tools to provide identical findings. I’m not even sure that it would be a good thing if they did. We need to take into consideration a variety of perspectives. The healthy thing is for some Rational Investors to point to the Tobin’s Q indicator, some to point to the P/E10 indicator, some to point to other indicators, and all to take a variety of perspectives into account in developing their own particular takes.
More important than the question of the differences between the two valuation-assessment tools is the question of whether it is reasonable to expect stocks to begin performing well once we get to fair-value price levels. The historical reality is that stocks always drop to price levels far below fair value in the wake of out-of-control bull markets. We saw the most out-of-control bull in history in the 1990s. Can we really feel safe betting our retirements on a hope that this time it will all turn out different, that this time we should expect stocks to begin a long-term upward move as soon as they touch fair-value price levels?
I don’t see that as being even a remotely safe way to proceed. It wouldn’t be a good idea to hold off on buying any stocks until we get to a P/E10 value below 10, as we usually do in the huge bear following a huge bull. But there’s a real risk that, if you buy heavily at fair value, you will see a 50 percent price drop before the emotional pain that will hit investors upon learning that Passive Investing has failed once again to work for the long term comes to an end. Even if we really are today at fair value, it is not necessarily a good idea to buy heavily into stocks just yet.
The other side of the story is that, if you got entirely out of stocks when prices went to la-la land, you probably should be inching your way back in today and planning a move to a significant stock allocation sometime over the next few years. I believe that P/E10 offers a better read of the realities than Tobin’s Q. But I am not sure. If it is Tobin’s Q giving the better read, it would be a mistake for most investors to stay entirely out of stocks too much longer. Stocks offer a strong long-term value proposition when purchased at fair-value price levels.
Perhaps the most important consideration is the emotional makeup of the investor making the allocation decision. If you have been following the Passive Investing model for some time, you are likely emotionally drained today and may need some time away from stocks to get your head straight and to start learning about more realistic investing strategies. I doubt that you’re missing a once-in-a-lifetime chance to get into stocks at good prices even if we really are at fair-value price levels today. The odds strongly favor a drop to price levels well below fair value in the wake of the sort of bull we experienced in the 1990s. So take your time before making a decision. Don’t make decisions in a panic. Work on feeling comfortable with valuation-informed strategies before making any dramatic moves.
If, on the other hand, you have long been a valuation-informed investor who has been longing for a chance to see prices good enough to justify purchasing stocks for the long term, and if you prefer Tobin’s Q to P/E10, you should be buying today. How about shifting to a stock allocation of 30 percent, or 40 percent, or 50 percent? You don’t need to jump from 0 percent to 70 percent in one fell swoop. Ease into things, continue to watch valuations, and move to a higher stock allocation when prices improve a bit more.
Personally, I want to see a likely 10-year return on stocks of at least 2 percentage points better than what I am getting from my TIPS and IBonds before moving into stocks. I view stocks as a risky choice until we see large numbers of investors giving up their attachment to the Passive Investing model. Can we really say that emotion has left the market until we see that happen? I am okay with taking on that risk if I am compensated for it. But for so long as stocks are offering a 10-year return no better than what is available to me from the super-safe asset classes, I don’t see the rational case for putting my retirement savings in jeopardy. We are still in the red-alert-danger-zone, according to the P/E10 tool. We still should be anticipating a price drop of 50 percent or more.
Things are changing, however. That’s the news that I take from the encouraging Tobin’s Q numbers. Stocks are still overvalued or at best fairly valued. But we are on our way to price levels at which stocks will again offer a very appealing long-term payoff. We all should be planning to up our stock allocations over the next few years. The smart investor avoids panic moves by using the historical data to anticipate what is likely coming in the next few years.
We still need a significant price drop for stocks to become an appealing long-term buy. But we no longer require two or three or four significant price drops to get to that magic place. We are closer to reasonable stock prices than we have been at any time since the mid-1990s. That’s good news indeed.
I’m just joking around. Here is some of what Frank has to say about my favorite investing calculator in the whole wide world, the one that changes everything forevermore.
Juicy Excerpt: Taleb provides compelling evidence why the future cannot be predicted based on historical empirical observations. The reasoning is that the majority of that which impacts our world is the result of Black Swans which are inherently unpredictable…. When Rob runs his regression algorithms, he is not taking into account the billions of variables that had an effect on the markets in the past that may not exist in the future….
Frank is bringing something important to the table. Anyone who thinks that he or she can use the Return Predictor as his or her only source of investing guidance is a fool. That’s my take. And I think it would be fair to say that Frank agrees.
Where I part company with Frank is re his suggestion that someone who does not use the Predictor or some similar tool is not also a fool. I think that it would be just as much a mistake to fail to take into consideration how stocks have always performed in the past as it would be to consider only how stocks have always performed in the past. How stocks have always performed in the past is not the only thing that matters. But how stocks have always performed in the past does matter.
Is it possible that we will see something worse than what we have ever seen before? It is possible. But how likely is it? Black swan scenarios are by definition uncommon. They can turn up and people need to know that they can turn up. People need to consider the possibility of black swan scenarios in their planning. It makes all the sense in the world for someone to say “I am going to put a bit less into stocks than the Predictor indicates is wise because the data used to construct the Predictor covers a time in which there were no black swan events and yet these are a real possibility.”
What I don’t think makes sense is to be paralyzed by the possibility that a black swan scenario may turn up. It is true that this may happen. But what are we to do about it? What are the practical implications of an acceptance of the possibility of a black swan scenario? Are we to avoid stocks altogether? Is that a realistic way to go? I don’t see it.
Things would have to get pretty darn bad for us to see stocks perform worse than they ever have in the past. In the wake of the bull market of the 1920s, we saw a drop in stock prices of 89 percent. Anything less than that is something less than a black swan event, a possibility that is taken into consideration by those using the historical stock-return data as guidance re what may happen in the future. I don’t rule out the possibility that we could see something worse than that. I don’t let it paralyze me, however. I view the possibility of a black swan event as something that we just need to live with, like we live with the possibility that lightening might strike us dead someday.
The purpose of the Predictor is not to persuade people that black swan events will not turn up. It is to persuade people that, when they look to the historical data for guidance re how stocks may perform in the future, they should examine the data in analytically valid ways. We all consider what has happened in the past when investing, whether we acknowledge it or not. How can a stock investor not consider how stocks have always performed in the past? The point of the Return Predictor is to encourage people not to fall for the idea that always becomes popular when prices are where they are today, that this might be the first time in history when valuations will not affect future returns. The danger of falling for that one is a high-probability danger, one that has been causing the ruin of investors since the day the first stock market opened for business.
Please do consider the black swan possibilities. They are real. But please don’t get so worked up over black swan scenarios that you fall victim to the far greater risk that this will be the first time in history when following the Passive Investing model will work out in the long run. The historical data says it isn’t going to be that way. The smart bet is that things will probably turn out this time at least somewhat as they always have before.
Long shots sometimes come in. People are always amazed when they do but the reality is that from time to time they do. That said, it’s not a smart idea to bet all your retirement money on a long shot. You should be taking into consideration how stocks have always performed in the past when deciding how to invest today.
Could stock prices begin going up soon and then continue going up for a good bit of time?
Yes, that could happen.
The Stock-Return Predictor tells us that the most likely annualized 10-year return today is 1.8 percent real (the numbers that apply when this blog entry appears may not be precisely the same as those that applied when it was written). That’s not so hot. It becomes especially unexciting when you take into consideration how high the odds are that we may see a price crash in the not-too-distant future. If I am going to take those sorts of chances with my retirement money, I want to see a likely return of a good bit more than 1.8 percent.
But “most likely” is not the same thing as “definite.” If those going with high stock allocations today are lucky, they could see returns a good bit higher than 1.8 percent real. How does an annualized 10-year return of 4.8 real sound? There’s a 20 percent chance that we’ll see a return that high or higher.
Should you take a chance on stocks then? At least stocks give you a chance of earning a real return of 4.8 percent real. You don’t stand any chance whatsoever of earning a return that high today in TIPS or IBonds or CDs. Stocks have more potential.
I think you should take a chance on stocks. With a small portion of your portfolio.
Where I take issue with the conventional advice is that I say that you should not take as much of a chance with stocks as you would at a time when prices were at reasonable levels.
Stocks do indeed possess the potential to provide a nice return over the next 10 years. In that sense they are more appealing than TIPS or IBonds or CDs. Stocks also possess the potential to provide an absolutely horrible return over the next 10 years. There’s also a 20 percent chance that the annualized 10-year return will be a negative 1.20 percent real or something worse than that. The super-safe asset classes are providing low returns today but they aren’t providing negative returns.
Everyone agrees that stocks are the more volatile asset class. Everyone agrees that the distance between the potential up for stocks in 10 years and the potential down for stocks in 10 years is considerable. On those two points my thinking and the conventional thinking are in line.
The problem with the conventional advice is that it does not point out the extent to which the potential ups and downs of stocks change with changes in the valuation level. The conventional view is that stocks always offer a better deal than the super-safe asset classes and that you thus don’t need to pay much attention to the effect of valuations.
The historical data does not back up that claim. The historical data shows us that there are times when stocks offer a deal so much more compelling than the super-safe asset classes that it is hard to make a reasoned argument for not going primarily with stocks and there are other times when it is a close call and there are yet other times when the super-safe asset classes offer the better deal. My take is that the super-safe asset classes generally offer the better deal today.
If you believe that stock returns are going to be on the lucky side of the spectrum of possibilities, you should invest accordingly. We are not able to see into the future to the extent needed to know with precision what return stocks will provide over the next 10 years. My goal in encouraging use of the Return Predictor is to educate you about the odds. If you know what the historical data says about the odds of the various outcomes, you are investing in an informed way.
Combine that with a little bit of luck and you’re on your way!
I often note that, on the three earlier occasions on which U.S. stock prices went as high as they are today, we experienced an average price drop of 68 percent. There is no one number that tells you all that you need to know about stock investing. So I will today direct a few words to an effort to putting that 68-percent-price-drop number in context.
It is of course possible that we will not see a price drop that big. Today’s P/E10 level is 24 (this blog entry was written in advance, so this number may be slightly out of date when you read these words). In the mid-1960s we saw a P/E10 level of 24, but the subsequent price drop was only 56 percent. That could happen again.
Or it could be that we will not even see a price drop of that magnitude. We have only been to a P/E10 level of 24 three times. The fact that we have never seen a price drop in these circumstances of less than 56 percent is certainly an indication that it is not wise to rule out seeing a price drop of at least that magnitude this time. But three spins of the wheel is not very many spins of the wheel. It could be that this time we will see a price drop of a bit less than 56 percent. Perhaps our small sample of return patterns is biased to the down side. We know that we cannot count on that. But we do not know with certainty that it is not so.
A price drop of 68 percent sounds real, real bad. Think about it a bit and you will see that it is not quite as bad as it first appears to be. The 68 percent price drop does not take place in a single year. It is spread out over time. It might be that you would suffer a loss of something in the neighborhood of 20 percent for four years in succession, or even that there might be some up years mixed in with a greater number of down years in a way that produces an overall loss of 68 percent when all the ups and downs are mixed in together. The loss of wealth is of course still very bad. But a loss that takes place over a good number of years will not be experienced as being nearly as dramatic an event as one that took place quickly. It would not surprise me if many investors will not even be aware that they have suffered a 68 percent hit after they have done so.
The 68 percent hit is the hit that applies at the worst possible moment. At all times other than the worst possible moment, the hit will be less than that. If you go far enough out into the future, there will be no hit at all. If you go far enough out into the future, there will be a big gain. It helps to keep these things in perspective.
Presuming that you are not going with a 100 percent stock allocation, you will not be seeing a 68 percent drop in your overall net worth number. If stocks comprise 90 percent of your portfolio, your overall hit will be about 60 percent. If stocks comprise 60 percent of your portfolio, your overall hit will be about 40 percent. If stocks comprise about 30 percent of your portfolio, your overall hit will be about 20 percent.
The 68 percent number does not incorporate the effect of dividends earned during the time the price of your stocks was falling. Including dividends (which is proper) makes things sound a lot less dramatic. John Walter Russell did research showing that the loss with dividends included might be only 40 percent. In a world in which most investors were better informed about the realities of stock investing, I think the 40 percent number would be the better one to report. The reason why I usually report the 68 percent number (and then add a mention of the 40 percent number if space permits) is that investors have been (improperly, I think) trained to think in terms of stock price changes rather than in terms of real net worth changes (which are more significant, in my assessment).
Stocks are in the Red-Light-Danger Zone today. Stocks are dangerous at today’s la-la land price levels. The potential for a big price rise is small. The risk of a big price drop is big. I believe that most investors (those not possessing strong stock-picking skills) should be limiting their stock allocation to 25 percent or 30 percent until prices return to more reasonable levels.
Still, I don’t think it is at all a good idea to exaggerate the risk that applies. Exaggerations cause emotional reactions. When Passive Investing enthusiasts underplay the risks of owning stocks at these prices levels, they encourage emotional reactions when the price drops come. It’s just as much of a mistake for Rational Investing enthusiasts to overstate the risks.
A 68 percent price drop is a serious thing. The fact that the historical data says that that is the price drop we need to be prepared for today is not a reality to be ignored. But a 68 percent price drop is not the end of the world. Do you know what happened on those three earlier occasions in which we experienced a average price drop of 68 percent? Stock prices shot up from the depressed levels that investors’ negative emotions had taken them. Lots of folks got rich in the aftermath of those earlier price drops.
Middle-class investors as a collective unit are likely going to experience a severe hit in years to come. Those positioned to survive the hit are likely going to amass large amounts of financial freedom quicky indeed in the aftermath.
Today’s Passion: If you’re not prepared for the good times just now beginning to be visible on the distant horizon, read the article entitled Stock Boom Facts and start salivating.
“I’ll venture a regular guy opinion. I will say that Rob’s explanation does make sense. However, no one can predict the future. Just when someone uses history to try to backtest, create a model, and then predict the future, the factors change or new factors emerge, thus making the model useless for predicting the future.”
Is he right?
Yes, to a large degree he is right. There is no backtest that can tell you what stocks are going to do in the future. It’s dangerous to think that there could be such a thing. Chip’s common sense has generated for us a warning that we all need to keep in mind.
But what about the Return Predictor? Isn’t that the product of backtesting? When I agree with Chip, aren’t I rejecting my own tool for learning how to invest successfully?
I don’t think so.
Chip is absolutely right that we are going to see new factors emerge in coming years that will affect how stocks perform. The Return Predictor looks only at how stocks have always performed in the past. It cannot look into the future. It cannot anticipate factors that have not emerged yet.
Where Chip goes wrong is in saying that, when new factors emerge, it will render the Rational Investing model (the Rational Investing model posits that valuations will always affect long-term returns) “useless.” When new factors emerge, it may be that we will need to make adjustments to the Predictor. It may someday even mean that we will need to develop an entirely new tool. It will not mean that we will need to reject the model by which today’s tool was developed. If it is true today that valuations affect long-term returns (I strongly believe this to be the case), then this will always remain true.
The question of whether valuations affect long-term returns is fundamental. We need to be able to answer that question correctly to come to possess any reasonable understanding at all of how stocks work. This always has been and always will be a critical question. Lots of new factors have come to our attention in the past and our process of learning about these new factors did not affect the importance of the critical factor. The emergence of new factors in the future will not affect this core matter either.
The Predictor is like a weather report. A weather report does not tell you for certain whether it is going to rain tomorrow or not. It tells you the odds. It lets you know whether you need to carry an umbrella or not. A weather report does not tell you everything you could possibly want to know about the weather. But it does offer valuable information bits. The same is true of the Predictor. It informs you as to how stocks work. It does not tell you all there is to know and it cannot tell you all there is to know because we fallen humans are not capable of knowing all there is to know.
Can we predict tomorrow’s weather? Not perfectly. But we are capable of providing valuable information bits about tomorrow’s weather. Those planning an outdoor event for tomorrow afternoon would be foolish not to take a look at the weather report. Those investing in stocks to finance their retirements would be foolish not to look at the Predictor as one tool for use in determining whether their current stock allocation is appropriate or not.
I don’t know what goes into the development of a weather report. But I am confident that there have been changes over time in the process by which weather reports are developed. The people who study the weather learn new things over time. As they learn things, they need to incorporate what they learn into their models. We’re always making small changes in how we go about predicting the weather and over time the effect of the accumulated changes can be significant.
It is going to be the same with our development of tools to predict stock returns. There is today no other tool on the internet that does what the Predictor does (my guess is that other such tools have been developed that are not publicly available, but that is just a guess). I believe that there will come a day when there will be hundreds of web sites that will offer such tools. There will be grand debates about how such tools should best be constructed. Over time we will learn new things and it will become possible to predict stock returns more effectively than we can today.
The Return Predictor is state of the art today. It is not always going to be state of the art. Chip is right that there are going to be new factors or that we are going to discover factors that were always there but that we do not know about today. That’s just the way life is. I don’t think we have to see it as a bad thing. It does indeed follow from a belief that life gets better that life is not perfect today but the positive way to look at it is that it is today’s imperfections that make it possible for life to get better.
Chip is living in the black-and-white world. He is thinking that, if the best tool available to us today is not perfect, we should not make use of any tool, we should give up on the idea of predicting returns. I see that as a dangerous mistake.
The reality is that we all predict returns. Those who never look at the historical data have some idea of what return they are going to obtain from their stock investments. If they didn’t have any idea whatsoever what to expect, they wouldn’t be able to bring themselves to put money down on stocks.
The difference is that those who use what the historical data tells us about how stocks have always performed in the past are basing their predictions on something rational, something objective, something solid. They are not just taking guesses, they are not permitting the emotions of the moment to exert too powerful an influence over their investing choices.
No one can predict the future perfectly. That’s so. But we all can make an effort. We all can learn what is available for us to learn. We all can try to invest more successfully in the future than we have in the past. The reality that we can never do this perfectly is no excuse for abandoning reason. To fail even to take into consideration what the historical data says is to abandon reason. That’s Passive Investing.
Today’s Passion:A recent moderator’s decision at the Early Retirement Forum shows how the ban on honest posting on SWRs and other valuation-related topics has remained in place despite the widespread community support for a lifting of the ban. The moderator closed a thread on “Tomorrow’s Market” that showed promise of helping lots of early retirees get a better fix on the realities of investing in stocks at today’s prices. Why did he do this? Because two Goons showed up on the scene and made every community member present uncomfortable with their ugliness. Why weren’t the two Goons removed so that the rest of us could have the discussions which we intended the forum to facilitate when we built it? Only the moderator who made the improper decision knows the answer to that one. What the two Goons learned is that they can get any promising discussion shut down by engaging in highly abusive behavior. They won’t forget the lesson taught them by the board moderator anytime real soon. And neither will the community members who put time and effort into taking the thread in a postive direction. Boo, baby!
Juicy Excerpt: Think of Rob as a buy-and-hold kinda guy with very infrequent reallocations, just like most sensible financial advisers. But Rob’s reallocations are really infrequent: only once a decade or so…. This plan isn’t really about market timing: it would have had you underweight equities for pretty much all of the big 1990s boom…. I think Rob’s approach has a lot to be said for it, but I do have a few problems with it.
Set forth below are my responses to several of Felix’s comments re the Predictor (Felix’s words are in italic):
I just don’t think that many investors have anything like the requisite amount of patience needed – where you can happily sit back for a decade or two waiting for the P/E10 to come down to the mid-teens before going overweight equities.
There is no question whatsoever that this is so today. Most investors have had the Passive Investing model drilled into their heads for so long that the idea of taking the price at which stocks are being offered into account when making allocation decisions sounds exceedingly strange. Given what we have heard from most investing “experts” over the past two or three decades, our finding (see The Scenario Surfer) that long-term timing has throughout history always beat rebalancing strikes many as counter-intutive.
The reality, however, is that it is Passive Investing that is strange, it is Passive Investing that is counter-intutive. We take prices into account when buying houses, cars, comic books and bananas. How could it be possible that stocks are the only asset class on the face of Planet Earth that operate according to an entirely opposite set of rules? Passive Investing simply does not make sense.
That’s a problem for those who try to practice Passive Investing during a secular bear. People need to possess deep confidence in an investing strategy to stick with it during hard times. It’s not possible to possess deep confidence in Passive Investing; the idea that prices don’t matter can never ring true to middle-class investors who have found that prices matter a great deal when making all of the hundreds of other types of purchases they routinely make.
Rational Investing (investing with an acceptance of the obvious reality that stock prices matter) is something new (speaking more precisely, it is something old than has been rediscovered after having been “forgotten” for the length of the most out-of-control bull market in U.S. history). It is going to take people some time to get used to the idea. This process cannot be rushed because long-term timing will not work any better than Passive Investing for those who do not possess deep confidence in it. The difference is that it is possible over time to develop a deep confidence in Rational Investing while this is not so with Passive Investing (investing as if stock prices did not matter).
I don’t believe that the stock-market asset class has rules which govern its long-term behavior
I like this statement because it is a clear and plain and direct and bold expression of a view that is held by many investors. We need to get these things out in the open and this statement does a good job of putting a topic that is too often evaded face-out on the table for discussion.
I do not share this view. I believe that there are indeed rules that govern how stocks perform and that it is very important that we do all that we can to discover these rules and to share what we learn with our fellow investors. My sense is that progress on this front has been held up for a long time because of the popularity won by Passive Investing during the huge bull and that we need to put confidence in this discredited model behind us to get about the business of learning the realities.
Rob Arnott has said that be believes we are on the threshold of a “revolution” in our understanding of how stock investing works in the real world. That’s my take as well.
I can easily believe that we will never again see the S&P 500 trading on a P/E10 of less than 15. (It’s already been 20 years…)
Again, this view is widely shared. Again, I take the minority viewpoint.
It’s not at all uncommon for secular bulls to last 20 years. So it shouldn’t be so surprising that it has been a long time since stocks have been undervalued. The big benefit I see in using the historical data as a guide to how stocks may perform in the future is that it gets us beyond the subjective impressions that we cannot help but adopt from watching stocks perform in one way for so long. For most humans, the way in which something works for 20 years is the way it works, period. For stocks, that rule does not hold. Stocks have been going through wild up and down cycles sometimes lasting for decades ever since the first stock market opened for business.
for people who like to take a 30,000-foot view of investing, this is a very handy little tool.
It cheers me to hear the Predictor described as a tool for use by those seeking “a 30,000-foot view of investing.” That’s a perfect way of describing it. Anyone who uses only the Predictor to inform her investing decisions is a fool. Anyone who does not use either the Predictor or some tool like it is also a fool, in my opinion. The Predictor obviously does not answer every question and obviously does not aim to. What it does, though, is to provide an historical perspective on how stock investing works that it is very hard to tap into though any means other than a review of the historical data.
The Predictor grounds you in an understanding of how stocks have always performed in the past not for the purpose of persuading you to accept that there can never be changes in how stocks perform, but to develop in you a healthy skepticism of the commonly voiced truisms that just happened to have become accepted as true during the most out-of-control bull market in the history of the United States.
I have seen many people react to the Predictor as if the only possible responses were 100 percent acceptance or 100 percent rejection. There are all others sorts of far more moderate and generally more interesting possibilities. It could be that the calculator gets some things right and some things wrong. There’s value in that if you possess the insight needed to distinguish what things it gets right from what things it gets wrong.
That sort of insight comes only from exploring the implications of the findings generated by the tool with both a healthy desire to learn and a healthy skepticism. The “it’s all good” and “it’s all bad” reactions tend to be conversation stoppers. We need to avoid dead ends and find ways to encourage lots of smart people to talk more about the questions brought to the table by the Predictor.
it gives me pause, too: I’ve worried for a while that stocks aren’t an attractive asset class any more.
That sounds real. And encouraging. I take these words as a sign that there are people opening up to the idea of looking at stocks in a new light. I view that as being good news indeed (stock investors could use some right about now, eh?).
The problem, of course, is that there’s not very much in the way of alternatives.
This is a very widespread belief that I do not share. The alternative to investing in overpriced stocks is — investing in fairly priced stocks! Fair prices always return. The returns earned on stocks purchased at fair prices are so great that they are well worth waiting for. It bugs me when people call me a bear because the primary reason why I avoid investing in stocks when they are selling at sky-high prices is that I love stocks and like the idea of being able to own so much more of them just by taking a little something off the table for a few years.
I don’t invest in TIPS at times of high stock prices because I love TIPS. I invest in TIPS at times of high stock prices because I love stocks and owning TIPS for a time permits me to come into ownership of more stocks down the road a stretch.
in any case, according to Rob, if I put all my money in stocks today, I can expect a real return of 5.65% over the next 30 years; 4.65% would be unlucky. I’d be happy with that, I think.
Stocks are a good deal even when purchased at today’s prices for those who hold for 30 years. I wish, though, that we saw more discussion of what is involved in holding stocks purchased at today’s prices for 30 years. My guess is that it is going to be a big bunch tougher to pull off than most of the investors who think of themselves as buy-and-holders realize today.
I am grateful for Felix’s blog entry. He made a good number of helpful observations on a good number of important points. I think he has pushed our debate over how stocks work in the real world forward in a significant way. Thanks, Felix!
Note: The statistical research that drives the Predictor was done by John Walter Russell, owner of the www.Early-Retirement-Planning-Insights.com site. Those interested in knowing more about where the numbers come from should check out John’s site.
Yesterday’s blog entry set forth the reactions of Steve LeCompte (author of the CXO Advisory Group blog) to The Stock-Return Predictor. John Walter Russell (co-developer of the Predictor) set forth his response to Steve’s comments in the Comments section of yesterday’s blog entry. I have set forth my response below (Steve’s words appear in italics).
Changes in market participation, regulations, financial services industry offerings and communications technology may have substantially modified the distribution of equity returns over the past century (e.g., decreasing volatility of returns).
Speaking strictly, the Predictor would be better termed a Reporter than a Predictor. The calculator merely reports how stocks will perform in the future assuming that they will perform in the future at least somewhat as they always have in the past. It essentially takes all of the historical data and sums it up in a few easy-to-compare numbers. There’s great value in knowing these numbers. But it is of course important to know the limitations of the methodology used to generate the numbers. Steve is pointing to one of the limitations.
It is entirely so that the Predictor does not take into account how the stock market has changed over the years. There are two reasons why I do not think that presents a big problem for the investors electing to make use of the tool.
One reason is that some of the changes that regularly take place will cause stocks to perform better and some will cause stocks to perform worse. There is a good chance that the changes will more or less even out over the long run. Perhaps not. But those who doubt that the pluses and negatives will more or less even out this time should bear in mind that it is very much the case that that is what has always happened in the past.
The Predictor assumes a far-out long-term return of about 6.5 percent real. There have been numerous occasions on which the majority of investors had come to believe that conditions had so changed that the number would permanently be a good bit higher or a good lower than 6.5 percent. The reality, however, is that we have always worked our way back to price levels where that is the number that applied. Thus, I think it is reasonable to use that number as a starting-point for an analysis of how things are likely to work out this time too.
The other reason why I believe that the possibility that things may turn out different this time is not so big a deal is that there is no law of the universe stopping the investor using the Predictor from incorporating her own beliefs about how stocks may perform differently in the future from how they ever have before into her own analysis. Say that you are trying to determine how long it will take you to drive from one location to another. Say that on ten previous drives it has always taken you two hours to complete the trip but that this time you know that there is work being done on the highway. You know that the trip is probably going to take longer than two hours. It’s not right to say that your prior drives provided you with no useful information. Knowing that the trip has always taken you two hours gives you a good starting-point for your analysis of how long it is likely to take to drive this distance under the new conditions.
So it is with the Predictor. Those who believe that stocks are now going to perform worse than they ever have in the past need to subtract a little something from the numbers generated by the calculator to obtain the numbers they will use in their own planning. Those who believe that stocks are now going to perform better than they ever have in the past need to add a little something to the numbers generated by the calculator to obtain the numbers they will use in their own planning. John and I designed the calculator to report the numbers that apply if stocks perform in the future somewhat as they always have in the past not in an effort to rule out the consideration of other scenarios, but only because there is no possible means of addressing every imaginable possibility and assuming that things will go more or less as they always have in the past is the most neutral option available to us.
Simplistically, there is always a reasonably diversified subset of the market with below-average PEs. If PE is reasonably prescriptive for future returns, then an investor could expect to outperform your calculator by continuously restricting investment to such a subset (e.g., “value” funds).
My e-mail to Steve directed him to the Predictor but did not make reference to the Valuation-Informed Indexing approach to investing. John and I certainly do not say that investors are limited to the returns generated by the Predictor. Those are the returns that are likely to apply for those following a Passive Indexing strategy. We strongly believe that far better returns are available to those who elect valuation-informed strategies. Valuation-Informed Indexing is one valuation-informed strategy; the approach described by Steve is another.
Whether an investor should adopt Valuation-Informed Indexing or an approach more along the lines of what Steve describes depends on her level of sophistication. I do not doubt that there are strategies that will provide better returns than Valuation-Informed Indexing. The benefit of Valuation-Informed Indexing is that it is as simple to implement as Passive Indexing.
A big part of the appeal of Passive Indexing is that it provides middle-class investors a way to invest without having to engage in lots of research aimed at determining which stocks or stock classes will do well. The big downside of Passive Indexing is that it is likely to lead to massive losses at times when stocks are as overpriced as they are today. Valuation-Informed Indexing provides all of the upside of Passive Indexing without forcing investors following it to endure the horrible downside associated with the more conventional indexing approach.
I expect that we will see exploration of many alternative ways to invest in a valuation-informed way in days to come. It is my hope that the Predictor and other calculators like it that I expect will be developed in days to come will help guide all of those explorations.
There are other asset classes besides U.S. stocks and bonds. These other classes may provide attractive (even conservative) alternatives with respect to return distributions.
Yes, there are many asset classes available to today’s investor. The reason why we contrast the prospects of a broad U.S. stock index with the prospects of Treasury Inflation-Protected Securities (TIPS) is that these asset classes stand at polar ends of the risk spectrum. Stocks are a high-risk asset class. TIPS come with a government guarantee and an inflation adjustment. Contrasting these two asset classes has helped us develop many powerful insights into how investing works in the real world.
For example. we have seen that at the top of the bubble there was a super-safe asset class that provided a likely 10-year annualized return a full five percentage points higher than the likely return for stocks. That reveals the often-heard claim that taking on added risk always leads to obtaining higher returns for the nonsense that it is. There are times when investors are compensated for taking on added risks and there are times when they are penalized for doing so; it depends on how irrational most investors have been in setting the price that applies for stock purchases at the time.
The Predictor does not have as direct an application for investors investing in asset classes other than stocks and TIPS. But it provides guidance for nearly all investors. Knowing whether stock prices are headed upward or downward over the long term, and the percentage odds of various returns along the spectrum of possibilities, opens up valuable insights to those considering investing in just about any asset class imaginable.
There is evidence that financial returns follow power law rather than normal distributions (as argued by Mandelbrot and Taleb — see http://www.cxoadvisory.com/blog/reviews/blog12-17-07/). Power law distributions are “wilder” than normal distributions and offer hardly any confidence for regression-type forecasting.
As John mentioned in his comments, we certainly do not rule out the possibility that investors will see results not yet experienced in the historical record. We cannot let the possibility that things may play out in ways never seen before stop us from doing the analyses needed to learn how to invest effectively in the event that the far more likely scenarios are the ones that play out. The calculator does not come with any guarantees. It offers insights to those interested in developing a sense of the future possibilities in the event that stocks perform in the future at least somewhat as they always have in the past. As Steve notes, however, Mandelbrot and Taleb have argued that it may not be entirely safe to go with that assumption.
The reality is that the historical data tells investors who bought stocks in the aftermath of the huge bull to expect exceedingly poor long-term returns. The most likely 10-year return starting from January 2000 was a negative number and the worst-case scenario was a 10-year annualized loss of over 7 percent real. Yowsa! My view is that a black-swan outcome would need to be pretty darn black to be worse than the worst-case scenario reported by the Predictor.
But, yes, it could happen, and it is a good thing to call attention to this possibility. I think it would be fair to say that anything that serves to deflate irrational exuberance is a good thing so long as we remain at the sorts of price levels that apply today!
Today’s Passion: A community member named Aaron tells us that the investing approach that we have developed through use of the Predictor “is what investing should be — calculated, deliberate, confident, informed and simple.”