Passive Investing is an approach in which you stick with the same stock allocation despite wild price swings. It became hugely popular during the wild bull. Its popularity is now in the process of bringing about the largest loss of middle-class wealth in the history of the United States (presuming that stocks perform in the future anything at all as they always have in the past).
The Stock-Return Predictor tells us that, at a time when the P/E10 value is 8 (the value that applied at the beginning of the huge bull), the most likely 10-year annualized real return for stocks is 14.5 percent. At a time when the P/E10 value is 44 (the value that applied at the end of the wild bull), the most likely 10-year annualized real return for stocks is a negative 1 percent. There is no stock allocation that makes sense both at a time when the likely 10-year return is 14.5 percent and at a time when the likely 10-year return is a negative 1 percent. Passive Investing is irrational.
Lots of smart people think it is a great idea. How come?
Say that you began investing in stocks at the time when the P/E10 value was 8. You obviously enjoyed great returns for a number of years. As prices climbed, your common sense told you that you should lower your stock allocation a bit. A voice from your dark side (you greedy cuss!) said “no, hang on, this money for nothing business is too cool!” The Passive Investing enthusiasts told you to pay attention to that voice. You did. You enjoyed more years of great returns.
Passive Investing is addictive. It works. And it works. And it works. And it works.
And then it doesn’t.
That’s how it has always happened. There’s an important sense in which what we are going through today is nothing new.
There’s another sense in which it is new, however. What is new is that this time Passive Investing paid off bigger and for a longer period of time than ever before. We never reached a P/E10 value of 44 before. The number that applied in the month before The Great Crash of 1929 was only 33. We shot way past that bad boy in late 1999.
So Passive Investing worked better this time than ever before, right?
Not right.
Extreme valuations are bad for middle-class investors. Yes, you make lots of money on the up. You then give it back on the down. The end result is not that you break even. The end result is that you are conned into believing that you are wealthier than you are, you make plans for the future based on what you believe your accumulated wealth to be, and then you see those hopes crushed. Middle-class investors are better off if stocks go up a steady 6.5 percent real per year.
Our belief in Passive Investing caused the huge bull. Rational investors would never have permitted valuations to climb so high. Our belief in Passive Investing put our minds in a collective fog. We let things get more carried away than we ever have before.
Most are going to wait until prices crash to term Passive Investing a loser. Not me. The financial losses we are suffering now are just the inevitable result of the crazy price jolts we saw in the late 1990s. The real problem is the craziness that Passive Investing injects into the investing system during up times, not the financial losses that inevitably follow when we are seeking to find our way back to sane price levels.
That’s my take. I don’t need to see the price drops to conclude that Passive Investing hurts humans and other smart, fun-loving mammals. My view is that the losses we suffer in a wild bear are just a natural consequence of the insanity we yield to during a wild bull. The damage has already been done. Passive Investing failed in my eyes when it caused the insanity of the late 1990s.
Please don’t think that I wish these losses on anyone. That’s always the accusation leveled at those who talk straight on stock investing. I want us to learn enough about stock investing to avoid both the insane price jumps of times like the 1990s and the painful aftermath of such eras of insanity. I focus on the cause of the pain rather than the pain itself because it is only by focusing on the cause that we can hope to help people. Bemoaning the price drops accomplishes nothing unless we use that pain to change our behavior during price cimbs.
Passive Investing causes the insanity that does in stock investors. The insanity is behind us; we are now in the early stages of recovery from it. That’s why I say that we do not need to see the price drops to conclude that Passive Investing has failed. This low idea has already accomplished its dirty work.
Today’s Passion: The article entitled Rational Investing vs. Passive Investing offers even more mean-spirited commentary about the most popular investing strategy in the history the world.
“Our belief in Passive Investing caused the huge bull.”
There is no evidence to support that belief. Only a small minority of investors employed passive investing during the huge bull.
By contast the vast majority of investors were employing active strategies like stock picking and trading in and out of stocks. During the late 1990’s as the cost of internet trades fell, day traders became increasingly common. As further evidence, the amount of turnover (buying and selling of stocks) by mutual fund managers has steadily increased.
Schroeder
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
Thanks to both of you for taking the time to share your thoughts with us.
Rob
The total return available to investors is the total returned by the stock market as a whole. Passive investing, by reducing costs to a bare minimum enables investors to capture the vast majority of that return.
If the stock market as a whole declines then no investing plan, VII or any other market timing scheme, can prevent the overall decline in investor wealth.
What you seem to miss Rob, is that if an investor wished to reduce their equity exposure, they need to find another investor who wished to buy.
Therefore it is impossible for “millions of middle class investors” to avoid these losses unless there are “millions of middle class investors” willing to incur those losses by buying their stock.
“Middle-class investors are better off if stocks go up a steady 6.5 percent real per year.”
With this statement you demonstrate your lack of understanding of investment. If stocks were returning a steady 6.5% real then investors would sell other investments returning less than a steady 6.5% real and buy stocks, driving up prices and lowering returns.
The reason for high stock returns is the risk of stocks, remove the risk and you will remove the reward, that will not happen.
What you seem to miss Rob, is that if an investor wished to reduce their equity exposure, they need to find another investor who wished to buy.
Yes, but at what price?
Fantasy valuations go “poof,” to paraphase Rob.
Have fun.
John Walter Russell
Those are helpful and thoughtful and important comments, Evidence-Based.
I am going to refrain from stating my point of view on the questions you raise because my voice is too dominant here. Community members need to think over other viewpoints and you have given us some words worth thinking over. It is better for people to focus on what you have said than to hear Old Farmer Hocus ring his same old bell again.
My inclination is to respond in a future blog entry, however. There are at least three points you raise here that merit a response from The Dangerous Fellow Who Finds Fault with Passive Investing.
You are one of my favorite posters here, Evidence. You help us out a lot by presenting the other side in an effective manner. I am grateful.
Rob
If stocks were returning a steady 6.5% real then investors would sell other investments returning less than a steady 6.5% real and buy stocks, driving up prices and lowering returns.
They do–over a period of 30 or 40 years.
Take out the speculative element and stocks do return 6.5% real.
Have fun.
John Walter Russell
And thanks of course also are due to you, John.
Oh, what the heck — thanks to the entire community!
Rob
They do–over a period of 30 or 40 years.
Take out the speculative element and stocks do return 6.5% real.
Which is what makes a passive diversified buy and hold investing approach such a winner for long term investors.
Fantasy valuations go “poof,” to paraphase Rob.
And when they do investors as a whole will suffer. No market timing scheme can create returns for “millions of middle class investors” if the market as a whole is tanking.
And when they do investors as a whole will suffer. No market timing scheme can create returns for “millions of middle class investors” if the market as a whole is tanking.
Investors as a whole would be much better off if we had long term timing. It would reduce such losses.
When Valuation Informed Indexing takes over, passive investors may have a chance–because of others.
Who will make money? Those who wait to buy at favorable prices.
Who will lose money? Those who listen to “experts” who tell them to buy regardless of market conditions.
Have fun.
John Walter Russell
Investors as a whole would be much better off if we had long term timing. It would reduce such losses.
Nonsense. If over a period of time the market returns 10% then that is the maximum that investors as a whole could receive. Such return would be reduced by costs.
No timing, short or long term, could increase the return to investors above 10%.
Nonsense. If over a period of time the market returns 10% then that is the maximum that investors as a whole could receive. Such return would be reduced by costs.
Right now, we have a bigger fool environment. Fleece the suckers. Passive investors don’t realize that they are today’s suckers.
There would be a narrower spread of outcomes.
No timing, short or long term, could increase the return to investors above 10%.
Investors could plan better.
In addition, different investors have different needs.
Have fun.
John Walter Russell
There would be a narrower spread of outcomes.
We have already dealt with this. If there was a narrower spread of outcomes, ie. less volatility, then prices would get bid up and returns reduced.
No. The INVESTMENT RETURN is generated by business earnings. It is stable. It is approximated by the Gordon Model.
The wide spread of outcomes is the result of the SPECULATIVE RETURN.
This is the long term observation.
Have fun.
John Walter Russell
The INVESTMENT RETURN might be reduced SLIGHTLY by a smaller average dividend yield.
Have fun.
John Walter Russell
The Investment return is highly dependent on the price the investor pays. If prices get bid up then investment return is lower.
The idea that you can get smooth 6.5% real returns in the stock market is a fantasy.
The idea that you can get smooth 6.5% real returns in the stock market is a fantasy.
I did not say that.
I said that the INVESTMENT RETURN is stable.
Over long time periods, the SPECULATIVE RETURN becomes a small fraction of the real, annualized, total return.
Over long time periods (30 to 40 years), the INVESTMENT RETURN is a stable 6.5% (real, annualized, with dividends reinvested).
Have fun.
John Walter Russell
Over long time periods (30 to 40 years), the INVESTMENT RETURN is a stable 6.5% (real, annualized, with dividends reinvested).
Here is what the return predictor says about that.
Stock Market Best Possible Lucky Most Likely Unlucky Worst Possible
30-Year Percentage Returns 7.57 6.57 5.57 4.57 3.57
40-Year Percentage Returns 7.15 6.25 5.35 4.35 3.35
I did not say that. I said that the INVESTMENT RETURN is stable.
A brief review of the earlier comments on this thread reveals that John is stating things correctly re what he said above.
As noted above, I am grateful for Evidence-Based’s contributions here. Evidence is making a sincere and serious effort to state the pro-Passive Investing position in a civil and reasonable way. Having people do that helps us all. There are many community members trying to make sense of all this and it becomes hard for us to do so if those who are convinced of the merits of Passive Investing do not feel comfortable sharing their sincere thoughts here.
The other side of the story is that it is obviously frustrating to say something and to have others change what was said into something else. To do that is to engage in word games and to engage in word games is a form of abusive posting. It is not the most obviously abusive type of abusive posting, but it does real harm. Lots of community time and energy has been wasted as a consequence of the failure of site administrators to step in and do something about word-game posting.
There are limits to how much of this sort of thing I will tolerate. Evidence-Based does not need to agree with John or with me re Passive Investing or anything else to be warmly welcomed to post here. I like Evidence-Based and I believe that he has valuable insights to share with us. So I very much want him to continue to contribute. I am sure that there are many others who feel that way. But I can only go so far in my tolerance of word games.
One way to avoid the danger area is to keep statements “I” based. “I” statements are generally safe. When you make a statement re what someone else said, you force him to respond if the statement is not accurate. And I do not want John or any other community member to feel the frustration that comes from having to respond too often to that sort of thing. So there is a point where I will shut down those who engage in word games re what others have said. I want the experience of posting here to be as pleasant as possible for all concerned. Smart people will not participate if it becomes unpleasant to do so.
Another tip is to keep things friendly. You can disagree with someone on an investing topic and still like the person and enjoy conversations with the person. Saying that you like the person with whom you disagree can help. Don’t just assume that people know it. Sometimes people need to hear the words. It can never hurt and there are circumstances where it can help a lot.
Another tip is to understand that these sorts of discussions have been going on since the beginning of time and will likely still be going on long after we all pass from the scene. There is no need to “win.” All should be shown the respect of being able to have their say. No one should feel that he or she needs to “win.” Ultimately, people do what they do regardless of what we say. The world is not going to turn on its axis regardless of which “side” “prevails” on a discussion-board debate.
There’s good stuff in this thread. People can learn from it. I am proud to be associated with the community that produced it. I am grateful to all who contributed for their efforts to help us all learn together.
Rob
Here is what the return predictor says about that.
It does not!
I’m just joking, Evidence. Using the Return Predictor to make your point is about as fair as you can get.
Thanks for hanging in there. I’ve been in your shoes (posting re a point I care about at a site owned by someone who strongly disagreed with me) and I know it is not an easy thing to pull off successfully. My view is that you are doing a great job.
Rob
“Our belief in Passive Investing caused the huge bull.”
This is totally wrong. A small minority of the market is ‘passively’ invested.
A small minority of the market is ‘passively’ invested.
Take a look at the discussions we have seen on our boards over the past six years, Weird. I think you will see that many of today’s investors do not see a need to make adjustments in their stock allocations when valuations go through dramatic changes. The idea that such adjustments are not needed is the Passive Investing idea.
It is that idea that has brought us to the price levels that apply today. If the “experts” were warning people on a regular basis of what has always happened in the past when we reached these sorts of valuation levels, you would be seeing huge sales of stock. Huge sales of stock would push prices back to reasonable levels. The reality is that it is not possible for stocks to reach the sort of price levels that apply today without large numbers of people being misled in very serious ways about the effect of valuations on long-term returns.
Rob
Think of all those “Lazy Portfolios” that succeeded so well during the bull market.
Experts got a lot of mileage by recommending “buy regardless of price.”
Have fun.
John Walter Russell
Think of all those “Lazy Portfolios” that succeeded so well during the bull market.
They would like you to think that they were the first ones ever to think of the idea of buying lots of stocks when stock prices were going through the roof.
They were not the first. It has been tried before. It has always ended in disaster for the middle-class investors who bought into the idea.
The benefit of looking at the historical data for guidance is that it tells you these things. Newspapers need to be popular to make money. Television programs need to be popular to make money. Web sites need to be popular to make money. The historical data feels no need to be popular. The historical data just tells you how things have always turned out when these sorts of ideas have been tried out in the past.
That is the value of the historical data — it exists outside of all the craziness that pushed prices up to unsustainable levels in the first place. The historical data is objective. It’s not influenced by its desire to turn a buck at a time when the vast majority of investors wants to hear fairy tales (if the vast majority were not so overinvested in stocks as to want to hear fairy tales, we obviously never could have gotten to these price levels in the first place).
The historical data rules!
Rob
“If the “experts” were warning people on a regular basis of what has always happened in the past when we reached these sorts of valuation levels, you would be seeing huge sales of stock. Huge sales of stock would push prices back to reasonable levels.”
This is extremely doubtful. If all ‘middle-class’ investors sold all of their holdings it would make for a worse-than-average down day but really nothing to write home about. Middle class investors own a very very small percentage of equity.
Middle class investors own a very very small percentage of equity.
The percentage is a whole big bunch bigger at these price levels than it is when stocks are priced reasonably. It’s the increase in middle-class participation that makes these price levels possible.
Bill Bernstein (p.156):“In the late 1960s, more than 30 percent of households owned stock. But by the 1970s and early 1980s, the number of stockholding families bottomed out at only 15 percent. It began to rise again, slowly at first, and then with the stock market’s increasing popularity, more rapidly. Currently, it stands at more than 50 percent of all households.”
Rob
The Bernstein comment is not a refutation. “50 Percent of Households” is an amount that is still quite small compared to the amount owned by institutional investors.
The number I’ve heard is that households own 10 percent of stock with institutional investors owning the other 90 percent.
Schroeder
The number I’ve heard is that households own 10 percent of stock with institutional investors owning the other 90 percent.
Who do you think the insitutional investors are holding it for, Schroeder?
It’s humans who earn money. It’s humans who invest money. It’s humans who overinvest in stocks when they begin hearing stories about how this might be the first time in which valuations won’t matter. It’s humans who suffer the pains that follow from falling for such obvious fairy tales.
Institutions don’t matter much in the final analysis, Schroeder. Institutions do the bidding of humans. If the humans wanted the institutions to pay attention to valuations, the institutions would do as they were instructed.
If 50 percent of households own stocks, it’s 50 percent of households that get harmed if Passive Investing becomes popular. The fact that there are some institutions playing middle-man doesn’t change that. Do you think these institutions are going to cover the losses for the millions who suffer busted retirements as a result of this Passive Investing gibberish?
Is it institutions making use of the Old School SWR studies?
It’s not. It’s humans.
It’s the humans that matter, not the institutions.
Rob
Constant inflation is one reason for high valuations. In days of yore, conservative savers put their savings in bank savings accounts at 5% interest. With no inflation, savers got a real 5% return (4% after taxes). Then inflation was dialed up, and savings account real returns became negative, and very negative after taxes. Citizens switched to inflation hedges instead. We now have a negative national savings rate because of this, and have to import all of our savings from overseas.
Two of the most popular inflation hedges are homes and stocks. Home prices were bid up greatly as a result, as were stock valuations. Now youngsters can’t afford the median home, and stock dividends are so low that future returns are compromised. The unintended consequence of constant inflation.
What a thought-provoking observation!
Thanks so much for stopping by, Inflation Hedge. I hope you’ll be able to take some time to join in our conversations here again.
A warm welcome to the Financial Freedom Community to you!
Rob
Rob, I would be very thankful if you could point out exactly where you think I was playing word games.
This seems to be a common trick of yours, throwing out the accusation of “word games” when ever you feel you can’t answer the point being raised.
I would be very thankful if you could point out exactly where you think I was playing word games.
This is discussed in some depth in Post #20 above, Evidence.
I have obligations to the other community members who post here and I intend to honor them.
I love your stuff, Evidence. Your name is high up near the top of my list of favorite posters at this blog. But I am not going to entertain further discussion of this point unless the exception noted below happens to kick in. It’s boring and it’s time-wasting and it makes us all look stupid to spend time discussing such an obvious point. You are an intelligent guy. I am personally confident that you get the message I was sending to you in the words above.
If you put up further word game-posts or further posts that complain about the deletion of word game posts, those posts will be deleted. If you put up further strong substantive posts (all the others by you on this thread fall into that category), those will appear here and I will thank you for going to the effort to put them forward.
I don’t believe in lifetime bans. I think that’s a dumb concept. So, if it’s okay with you to have some of your contributions appear and some deleted, that’s okay by me. I certainly will not hold any grudges. I will always be grateful for the good stuff you have put forward here.
If this policy annoys you so much that you elect to leave us, you will make me sad. I am confident that there are a number of others who feel the same way.
If you are able to craft something that convinces me that you have a sincere question re the word-game-post rule, I will let it in. I must tell you that I do not believe that the odds that you will be able to persuade me re this are good. If you want to take the time to craft a post just to see, feel free. It”s possible you will win me over. But I think it would be fair to say that it is a long-shot.
I thank you again for all the good stuff you have put forward here. In the event that we do not hear from you for some time, please know that we will be continuing to think of you from time to time and hoping that you at some point will see fit to visit us again. You are a part of our story. You have won a place in our hearts.
And that’s final! (Just kidding around re that last part.)
Rob
If you are able to craft something that convinces me that you have a sincere question re the word-game-post rule, I will let it in. I must tell you that I do not believe that the odds that you will be able to persuade me re this are good. If you want to take the time to craft a post just to see, feel free. It’s possible you will win me over. But I think it would be fair to say that it is a long-shot.
I don’t think it is a long shot, I think there is no chance at all. The posts on this thread are numbered. I contributed 4,9,10,12,14,17,19 and 32. You could if you chose to highlight which one contained the word games and directly quote what you considered to be the word game. You chose not to do so. Such is your history.
When I have wished to comment on something that you or JWR have said I have quoted directly, I wish you would do the same.
“Currently, it stands at more than 50 percent of all households.”
A bunch of mom and pops owning 10 shares of something is not a meaningful percentage of the market. Your quote is irrelevant and unrelated.
A bunch of mom and pops owning 10 shares of something is not a meaningful percentage of the market.
Mom matters. Pop matters.
Millions of busted retirements matter.
The depletion of millions of 401(k) plans matters.
And a lot of the moms and pops you are talking about do not own only 10 shares. Middle-class workers have been asked (told, really) in recent decades to take responsibility for the financing of their own retirements. The gibberish they have been told re Passive Investing is in the process of setting back their efforts by many years, in some cases by decades.
To the Normals, this matters. Big time.
If we were talking about any other field of life endeavor, human pain of this magnitude would matter to every single human being who read the words of this thread. It is my hope that there will come a day when the same rules that apply in all other fields of human endeavor will apply in the investing field as well. I think it is fair to say that, when that day comes, there will be lots and lots of people pointing out the flaws in the Passive Investing concept in the event that anyone dares to put it forward as something to consider yet one more time.
The mom and pop you deem insignificant are the readers in my mind’s eye to whom I direct all the words that appear at these pages. I cannot get mom and pop their money back. There are limits to my powers. But I can put forward a few words in their behalf when the efforts it took them to salt away the money it took to buy those 10 shares is denigrated. So this I do. I can do no more and I can do no less.
Rob
You could if you chose to highlight which one contained the word games and directly quote what you considered to be the word game.
I will try coming at this from a different direction.
Do you respect John’s research?
I am not asking whether you agree with it. I am asking whether you respect it.
There is no one in the history of the internet who has done more to help out a posting community than John has done to help out the Retire Early/Indexing community. You post over at the Goon Central board, where he is denigrated on an almost daily basis. Greaney set up an entire section of that site to denigrate John and his work. I do not recall you ever calling out Greaney on this, asking him to remove the trash from his site. Why is that?
It’s a serious question, not a rhetorical one. You have made good contributions to this thread and to earlier threads here. I believe that there are legitimate points that you are trying to bring to our attention that community members need to have brought to their attention. So I very much want you posting here.
But I do not want you posting here to the point where I am going to take a chance on making a poster like John feel inappropiately uncomfortable. No way, no how.
If you say “I disagree with you, John” and that makes John feel uncomfortable, then that’s just too bad for John. There’s nothing I can do for John in that circumstance because the overall community’s need to hear what you have to say trumps any concern over John’s feelings. If you put words in John’s mouth, that’s something different. In that case, I have a role to play.
None of us can see into your mind. None of us have perfect knowledge of your motives, except you (and it would not shock and amaze me if even you do not have perfect knowledge of your motives). I am not going to hold it against you that you participate at Goon Cental and say nothing about the stink that overwhelms any human who enters the place because I want our community to benefit from the good stuff you have demonstrated you are capable of putting forward. But I’m not going to say that I do not find something odd in it either. I find something odd in it.
It’s a waste of my time and your time and the community’s time for us to go around and around and around in the he said/she said games. It bores me. If you want to play games, find some other site. This isn’t the place.
If you have a point that you want to make re the blog entry that you don’t feel has yet been fully deveoped, please fully develop it. That would be a plus for all concerned.
If you have already made the point and you are now just annoyed about what I said in Post #20, please try to get over it. I have a job to do and I saw a case where my intervention as a precautionary move appeared to be needed and I intervened. You don’t seem to think that was right. Well, that’s life, my good friend. I’ve got a job to do and I intend to do it. It’s not your conscience that has to live with the results of the judgment calls, it’s mine. So I am going to make the calls that seem right to my mind, not necessarily the ones that seem right to yours.
The natural thing for you to do is to offer some explanation for your participation at Goon Central and some words about how you feel about the wonderful work John has done for us. That’s not required. That’s a suggestion. I suggest it because it gets to the point that matters a whole big bunch quicker than both of us putting up a string of posts citing earlier post numbers. That stuff is NoWheresVille.
John is a valuable member of this community and you are a valuable member of this community. The two of you obviously do not agree on the investing issues. I view that as a good thing. That means that if we get both of you contributing regularly, we are sure to hear more than one side of the story. Lucky us.
It’s unlucky us if we generate a string of posts citing an earlier string of posts citing an earlier string of posts. I don’t think your idea of how to go about straightening this out is the right idea. It’s too indirect and too bloodless. I believe in getting to the heart of the matter. You tell me how you feel about John’s research and about your own participation at the Goon Central board, and you provide me with important clues as to why you contribute to such filth at the other place and put forward such good stuff here. The better a sense of what is truly going on that I am able to develop, the more confidence I am able to feel in whatever decisions I make.
Again, there’s no requirement that you respond to this. It’s an option that you may elect to pursue or not as you think best.
I trust that puts the matter to an end.
No, seriously.
I’m not kidding!
Why is everyone laughing?
I really, really, really mean it!
Really.
Rob
“The mom and pop you deem insignificant are the readers in my mind’s eye to whom I direct all the words that appear at these pages. I cannot get mom and pop their money back. There are limits to my powers. But I can put forward a few words in their behalf when the efforts it took them to salt away the money it took to buy those 10 shares is denigrated. So this I do. I can do no more and I can do no less.”
Nice ‘word games’. In any case, it is not about ‘denigration’. Facts are facts, ‘middle class’ investors do not move markets. All of your pontification assumes that they do.
‘middle class’ investors do not move markets.
I disagree, Weird.
There’s a famous quote by one of the multi-billionaire tycoons that “bear markets are God’s way of returning stocks to their rightful owners.” The Bernstein quote at Comment #27 above shows how it works. Yes, it is the wealthy who own most stocks. But there is a regularly recurring cycle in which the middle-class is enticed to buy in heavily when prices are high and then to sell when prices are low. Stock prices could not get to where they are today without heavy middle-class participation and stock prices will not remain where they are today after the middle-class has been forced out because of the “discovery” that stocks are probably going to perform this time at least somewhat as they always have in the past.
How are middle-class investors persuaded to ignore the Iron Law of the stock market, that valuations have always had a huge effect on long-term returns and always must continue to have a huge effect in the future as a matter of “mathematical certainty” (Bernstein’s phrase)? They are told thousands of times in newspaper articles and on television shows and on web sites that there is no need to adjust their stock allocations when prices go from reasonably priced to dangerously overpriced. That’s the Passive Investing concept. That’s the Lazy Portfolio concept. It assures people that prices don’t matter despite the strong message of the historical data that since the first day the market opened for business prices always have mattered.
The end result is that the middle-class investor hears lots of stories about how stocks can offer great long-term returns (which in itself is a true claim) but then does not see those returns himself (except for the length of time for which the wild bull in which he is enticed to buy remains in effect). The typical middle-class investor ends up giving back much of what he gained during the wild bull in the wild bear that follows as a matter of economic necessity.
How do we break this chain of frustration so that middle-class investors can obtain those great returns that the stock market really does provide to those who invest rationally? By permitting middle-class investors to hear the realities of stock investing as revealed in the historical data. Stocks have always provided great long-term returns when priced reasonably. Stocks have always provided bone-crushing losses when priced as they are today. If middle-class investors knew this, they could develop allocation strategies that make sense and that they stand a reasonable chance of sticking with for the long-term. It’s very hard to stick with something that doesn’t make sense when prices are dropping hard.
Middle-class investors have been told that they must finance their own retirements, that their employers are not going to do it for them. So why not permit them to learn what they need to learn to invest successfully for the long run? Middle-class investors should be permitted to hear what the historical data says about the effect of valuations on long-term returns.
My sincere take.
Rob
“The typical middle-class investor ends up giving back much of what he gained during the wild bull in the wild bear that follows as a matter of economic necessity.”
Sure, this is what makes the ‘middle class’, middle class. They are the best and most clueless victims. In any case, they should learn to have more discipline. And this has nothing to do with buying into cooked-up whack-job schemes.
Is wild your new favorite word?
“Stock prices could not get to where they are today without heavy middle-class participation …”
If we use sentiment surveys of middle-class investors, we don’t find heavy participation today. For example, the AAII survey says that only 31% of their members are bullish on stocks. The following link is current as of 6/25/08 . . .
http://www.aaii.com/membersurveys/sentiment/press.cfm
So, Rob, I don’t see how you can say that middle-class investors, where only 31% are bullish on stocks today, can be described as participating heavily in stocks.
Schroeder
They are the best and most clueless victims. In any case, they should learn to have more discipline.
You and I see very different things when we look at the scene playing out before our eyes, Weird.
Middle-class investors work, right? That takes discipine. They save, or they wouldn’t have money to invest. That too takes discipline. And we have seen hundreds and hundreds of them asking questions on the various Retire Early/Indexing boards that evidence a desire to learn how stock investing really works. If middle-class investors are so clueless, why are they seeking to learn? It seems to me that the desire to learn evidences the possession of at least a clue or two that the official story does not quite add up.
Middle-class investors need to be more demanding. They need to ask for reasonable explanations not only one or two times. They need to keep coming back at those who put themselves forward as “experts” until they hear answers that make sense. When being told about stocks by people with ties to the stock-selling industry, they need to push as hard as they would when being told about cars by people in the car-selling industry. They need to be more skeptical. They need to be more practical. They need to be more self-interested. They need to be more concerned about their fellow middle-class investors.
I think that the problem is that they are intimidated by the big words and the fancy graphics and the complicated theories that people in the stock-selling industry employ to make their case. What I hear when I listen to middle-class investors struggling with their confusion is a feeling that they have not studied these matters well enough to dare to question people who make a living in the field. They cannot imagine how little even some of the biggest names in the field really understand on a deep level.
We all need to become a lot more skeptical. Not out of cynicism. Out of kindness. We do the experts wrong when we take what they say as gospel without checking it or or drilling down. If we pushed the experts harder, I think a lot of them would admit that there’s a lot that they do not know. That would let them off the hook to a considerable extent. I get the feeling that a good number of the experts would like to acknowledge that there is a whole big bunch that they do not understand clearly. But each one feels funny being the one to say that he doesn’t know when the others are saying that they’ve got it all figured out and that they have found The One Right Way and it is Passive Investing.
I don’t think we are dumb. I don’t think we lack discipline. I do think we are likely going to suffer one of the worst hits ever suffered. I see it as being largely because of the counter-intuitive way in which stocks work. Stock investing is not complicated. But it is counter-intuitive. It’s hard for our human brains to accept that just at the time when everyone thinks stocks are perfectly safe and is 100 percent confident that we’ve got it all figured out, stocks are the most dangerous investment class they have ever been.
And that is indeed the reality. It’s because so many have come to believe in recent decades that Passive Investing is The One Right Way that Passive Investing is in the process of causing the largest loss of middle-class wealth in the history of the United States.
Rob
I don’t see how you can say that middle-class investors, where only 31% are bullish on stocks today, can be described as participating heavily in stocks.
I can say it because I’ve seen the effect that a belief in Passive Investing has had on people’s attitudes, Schroeder.
I can believe that most are not “bullish” today. I see the concern re where stock prices are going on all the boards.
What I also see is a lot of people not listening to their common sense and trying to stick with their high stock allocations despite the fact that stocks are today so wildly (take that, Weird!) overpriced. That’s the effect of the widespread belief in the Passive Investing concept.
Common sense tells us that, when stocks offer a poor long-term value proposition, we should lower our stock allocations. Passive Investing tells us that we should stick with stock allocations that were right at times of reasonable valuations even when prices go totally out of control. That of course makes zero sense. But Passive Investing is not an intellectual concept. It is a purely emotional concept. It is the product of rationalization, not reason. There’s a difference.
The move upward to a P/E10 level of 44 (the highest on record by far) was the triumph of the Passive Investing concept. Passive Investing was never more popular than it was in January 2000 and stock investing was never a more irrational endeavor than it was in Janaury 2000. We are now in the process of finding our way back to more reasonable price levels (which we must if the markets are to continue to function). We are also in the process of losing confidence in the Passive Investing concept.
But that doesn’t happen overnight. That takes time. The fear that people feel today over what is going to happen to their retirement accounts in days to come is a healthy fear. That fear is a sign that common sense has not entirely died out among middle-class investors. But Passive Investing is still working its black magic on our investing decisions. Lots of people know that they should be lowering their stock allocations but are holding off because of a vague feeling that maybe those people touting Passive Investing know more than they appear to know.
They don’t know more than they appear to know. They know less than they appear to know. I’m sure of it!
Rob
Well, you certainly wrote quite a few completely inaccurate and rambling things but I will pick out a few of the more completely wrong ones.
“Middle-class investors work, right? That takes discipine. ”
No, they work because they have to eat.
“They save, or they wouldn’t have money to invest.”
They tend to spend more than 100% of their incomes so they do not really save either.
“I can say it because I’ve seen the effect that a belief in Passive Investing has had on people’s attitudes, Schroeder.”
This is anecdotal rubbish.
“It’s because so many have come to believe in recent decades that Passive Investing is The One Right Way that Passive Investing is in the process of causing the largest loss of middle-class wealth in the history of the United States.”
This is again, completely wrong. A very small minority of investors and investment dollars are invested passively.
I know you are really trying hard to find something to sell but you should actually use positions that hold up under a ‘first glance’ scrutiny.
they work because they have to eat.
You evidence an hostility to middle-class investors that I do not share, Weird.
A very small minority of investors and investment dollars are invested passively.
Then how do you explain today’s high prices? We are today at one of the highest valuation levels ever seen in U.S. history. Would you say that that’s the product of Rational Investing?
So long as investors remain rational, prices self-correct. If ever stock prices get so high that the long-term value proposition of stocks drops enough so that less risky asset classes offer a better deal, rational investors sell stocks to lower their allocations until things are brought back into balance (in a rational world, stocks should offer better returns because there is more risk in stock investing and stock investors should be compensated for taking on that risk). You don’t see that today. You see sky-high prices but not enough sales of stocks to bring prices back to reasonable levels.
That’s Passive Investing, Weird. That’s the concept.
Look at some web sites that deal with investing. At most of them, you will see arguments that investors should just stick to their old stock allocations regardless of today’s prices. Do you think that’s a coincidence? It’s that sort of argument (the Passive Investing argument) that is causing prices to remain so high. For prices to drop, we need to see lots of investors selling lots of stock. You won’t see these arguments so much when prices return to reasonable levels. You’ll know that Rational Investing is on its way to returning to popularity again when you see prices falling hard.
The worry, of course, is that when that happens we will see the Passive Investing enthusiasts becoming equally emotional in the other direction. The pattern with emotional investing is to argue for high stock allocations when prices are high and the long-term value proposition is low but then to argue for low or zero stock allocations when prices are low and the long-term value proposition is high. While extreme high prices signal irrational investing, extreme low prices do not signal rational investing.
Extreme low prices are also irrational. Just as Rational Investing causes prices to drop when they are too high, it also causes prices to rise when they are too low. Rational investors buy more stocks when prices are low (they buy the very shares the Passive Investors have finally decided to sell!). Passive Investing/Emotional Investing is dominant at times of extreme prices in either direction. Rational Investing may be dominant at times when prices are near fair-value levels (there are of course cases in which prices are at fair value for a time only because they are mid-way on the path from being too high to being too low).
Rob
“Then how do you explain today’s high prices?”
According to Shiller, 2003.02 earnings were 29; S&P 500 was 837. By 2007.06, earnings grew to 84; S&P 500 was 1514.
Prices follow earnings. Earnings go up, prices go up.
Schroeder
“You evidence an hostility to middle-class investors that I do not share, Weird.”
What is hostile? If you asked 10000 middle class people they would all have the same answer. They work because they want things and they need to eat. Most people don’t enjoy their work so the only explanation for why they do it is money. If they had no money, they would be destitute. If this is not obvious, I do not know what is.
“Then how do you explain today’s high prices? We are today at one of the highest valuation levels ever seen in U.S. history. Would you say that that’s the product of Rational Investing?”
I don’t have to explain it and that is not my intention. My point is that your explanation is complete nonsense and is not supported by any facts at all. It is just a fantasy you are weaving to support your own agenda. Facts are facts. Rapid turnover and trading, extreme shifts in allocations, and the like, are much more common than passive investing.
Prices follow earnings. Earnings go up, prices go up.
I like your comment, Schroeder.
I like it because I think it helps to clarify the core distinction between the two models of understanding how stocks work.
You believe in Passive Investing. Passive Investing is rooted in the Efficient Market Theory. The idea here is that investing is primarily a rational endeavor. The idea that it is earnings that cause prices to go up is a take that begins with an assumption that investors are highly rational.
I believe in Rational Investing (the idea that prices must affect long-term returns). Rational Investing is rooted in the Behavioral Finance model of understanding how stocks work. The idea here is that it is human emotions that exert the primary influence on stock prices. Ironically, the Rational Investing approach begins with an assumption that investors are often highly irrational (the thought here is that it is only by acknowledging our propensity to be swayed by irrational impulses that we can hope to invest in accord with what our reasoning processes tell us).
I certainly don’t say that earnings have zero effect and I know that you do not say that emotions have zero effect. But because of the model you use you are always drawn to rational explanations of what you see take place before your eyes. In contrast, because of the model I use I am always drawn to emotion-oriented explanations of what I see take place before my eyes. We see the same things. We offer very different takes on what we see.
Each investor has to decide for himself or herself which model to follow. The fact that you are confident in your model does not make your model right. The fact that I am confident does not make my model right. People have to look at all the evidence they have time to look at and then take a leap of faith. Which model is chosen has a huge effect on the investor’s ultimate success or lack thereof. The future will reveal the realities.
Or perhaps not. Perhaps The Great Debate will continue on into infinity. I certainly think it would be fair to say that these questions have been debated by investors for hundreds if not thousands of years now. Perhaps there is nothing new under the sun. Perhaps the pendulum swings one way for a time and then swings another way for a time.
In any event, I am grateful for your contribution to our discussions.
Rob
If you asked 10000 middle class people they would all have the same answer.
Not if I were one of the 10,000, Weird. If I were one of the 10,000, I would take the comment as an insult.
They work because they want things and they need to eat.
That’s certainly one reason why I work. It is certainly not the only reason.
There are lots of reasons why I work. I work to have something to eat. I work because I like to learn stuff. I work because I like to make new friends. I work because I enjoy a challenge. I work because I want to have money to leave to my children. I work because it heals my soul. I work because I love work. There are scores of other reasons.
When you suggest that I work only for food, you suggest that I am some sort of low-level animal or insect (even dogs and cats engage in effort for reasons other than finding food to eat). I find the suggestion highly insulting.
The context in which this came up is that I said that the fact that middle-class investors work shows that they possess discipline. You disputed that. You suggested that most of us are slugs that only bother to get out of bed and go to work because we feel hunger pangs. I strongly disagree. If that were the only reason any of us worked, none of us would ever rise above doing the most basic jobs. If all we wanted was food to eat, why would we put so much effort into advancing and developing our skills and earning promotions? If all we wanted was to satisfy our bellies, why would we take such pride in the work we do?
I don’t see what you see even a tiny little bit, Weird. I mean no offense to you personally and I suppose that there’s some sense in which I am glad that you shared your thinking re this topic with us. But I find your understanding of what drives middle-class investors highly offensive both to me and to my fellow middle-class investors.
Most people don’t enjoy their work
I think it would be fair to say that you hang around a very different group of middle-class investors than I do, Weird. I have known people who were frustrated re some aspects of the work they do. Most people I talk to enjoy at least some aspects of their jobs. Many flat-out love their work. Just about all are at least hoping someday to do work they love. I view your vision of middle-class life as a dark vision indeed. Please excuse me for saying so, but it reminds me of the Greaney vision (please see the article entitled “Eight Paths to Financial Independence” in the “Community Rules!” section of the site).
Rapid turnover and trading, extreme shifts in allocations, and the like, are much more common than passive investing.
Passive Investing is very common today. I have heard many middle-class investors express the thought that despite their worries over where stock prices are headed, they are inclined to accept the advice they have heard from “experts” that the best thing is just to maintain their current stock allocatiions. That’s what the reckless Passive Investing theory looks like when given expression in the flesh-and-blood world. When people put these sorts of ideas forward for long enough, we get to a point where other people lose big heaps of money as a consequence of following them.
Millions of people are making decisions about how to invest their retirement money with this “idea” influencing their thought processes. I view this idea as being the primary reason why millions of middle-class retirements are at great risk of going bust in days to come (the Old School SWR studies are the product of the same school of thought as the one that brought us Passive Investing).
Yucko McGlucko! And that ain’t no jive and shucko!
Rob
“When you suggest that I work only for food, you suggest that I am some sort of low-level animal or insect (even dogs and cats engage in effort for reasons other than finding food to eat). I find the suggestion highly insulting.”
Well, I find it exceedingly arrogant to assume that we are not just like other animals. We are really amazingly worse. We invent concepts like ‘God’s special creation’, etc, to justify our cancerous consumption of this planet and our abuse of its resources.
You are right, of course, we do not just work for food. We work for more food than we could ever possibly consume and if it all spoils because we cannot consume it – so what?
“I think it would be fair to say that you hang around a very different group of middle-class investors than I do, Weird.”
Obviously, you are one of these people who did not enjoy their work – why else quit and put your entire family at risk? This statement is quite ironic!
“Passive Investing is very common today. I have heard many middle-class investors express the thought that despite their worries over where stock prices are headed, they are inclined to accept the advice they have heard from “experts” that the best thing is just to maintain their current stock allocatiions.”
Rob, it does not matter what you ‘hear’. This is useless anecdotal information – unless of course you are constructing something to be sold to these poor anecdotal souls. You cannot design ‘retirement solutions’ around things that you ‘hear’ while perusing the Internet.
We work for more food than we could ever possibly consume
Ouch! You’re hitting a little close to the nerve with this one, Weird.
Take care, my new friend.
Rob