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.”
That reveals the often-heard claim that taking on added risk always leads to obtaining higher returns for the nonsense that it is.
I would be interested in reading your justification for the statement that “added risk always leads to obtaining higher returns” is an “often-heard claim”.
I have only ever seen such comments coming from uninformed people constructing straw man arguments.
In fact the use of the word “risk” demonstrates that the higher returns are not guaranteed.
“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.”
Smither’s chart says stocks are not as overpriced today . . .
http://www.smithers.co.uk/page.php?id=33
the use of the word “risk” demonstrates that the higher returns are not guaranteed.
That’s what common sense tells us, Evidence.
It’s not what Passive Investing enthusiasts tell us.
Go to the Bogleheads board and point out that the historical data shows that it was likely back at the top of the bubble that the 10-year return for stocks was going to be a negative number. You will find a number of community members expressing interest in learning more about the realities of long-term stock investing. You will also hear a number of intensely dogmatic Passive Investing enthusiasts saying that it is impossible for TIPS to offer a 10-year return a full five percentage points higher than stocks because stocks are more risky and investors should demand compensation for taking on the added risk.
It is entirely so that investors should do this. If investing were a rational endeavor, the risky asset classes would provide higher returns. In the real world, investing is a highly emotional endeavor. There are times when emotional investors set stock prices so high that the long-term value proposition is dismal indeed. The Passive Investing model does not permit consideration of these realities. That’s why this model always fails in the long run.
Rational Investors go with higher-risk asset classes when they are adequately compensated for doing so and not otherwise. Rational Investors go with safe asset classes when safe asset classes offer more appealing long-term value propositions than risky asset classes.
Rob
Smither’s chart says stocks are not as overpriced today
Thanks for bringing this to our attention, Schroeder.
This is an important development. Smithers is one of the best-informed valuations analysts around. He’s not a Passive Investing advocate.
We learned about this from a thread posted at the Bogleheads board the other day. I plan a blog entry exploring the implications for Rational Investors.
Rob
It’s not what Passive Investing enthusiasts tell us.
Again, I would be interested in some evidence of this. In reality the Bogleheads board is one of the few places that has consistently emphasized the risks of stock investing and has always recommended holding bonds.
If investing were a rational endeavor, the risky asset classes would provide higher returns.
If higher returns were guaranteed there would be no risk.
Again, I would be interested in some evidence of this.
It’s omni-present in the literature of Passive Investing enthusiasts, Evidence. The standard response to the observation that stocks are priced too high today to provide a strong long-term return is that stocks are a high-risk asset class and that there is some magical pixie dust somewhere that insures that high-risk asset classes always provide better long-term returns than low-risk asset classes.
The “magic pixie dust” phrase is my own addition. But the Passive Investing enthusiasts don’t offer any better explanation for why they believe this. They just repeat it over and over and over again without offering any reason for why they believe it.
If you press hard enough, you will uncover a belief that investing is 100 percent rational. That’s the source of this nonsense. If investing were a 100 percent rational endeavor, investors would indeed insist on being compensated for taking on added risk. And of course this is indeed usually the case. But there are times (like today!) when investor emotions go haywire and the highest-risk asset class offers a very poor long-term value proposition indeed.
Rob
In reality the Bogleheads board is one of the few places that has consistently emphasized the risks of stock investing and has always recommended holding bonds.
It certainly is true that they pat themselves on the back for doing this every 15 minutes or so.
The reality is that there are many, many people at that board who are perfectly sensible and who have expressed a desire to learn more about the realities of long-term stock investing. There is also a group of extreme dogmatists led by Mel Lindauer that shuts down any discussion of the realities as demonstrated by the historical stock-return data. It was this group that burned the Vanguard Diehards board to the ground.
If the Lindauerheads are so open to learning about the true risks of stock investing, why do we see these dogmatic reactions from them, Evidence? If they are open to learning the realities, why did they burn the Diehards board to the ground?
The picture you are drawing for us just does not square with the realities we have seen play out before us during The Great Debate. If you are saying that most participants at the board are reasonable people, I’m with you. If you are saying that the Lindauerheads are open to learning the realities and to permiting others to hear about the realities, I am afraid that we are going to have to agree to disagree re this one.
Rob
Rob
You seem to be struggling with the concept of risk and reward. I think the best coverage that I have seen of the subject is in William Bernstein’s The Four Pillars of Investing
“Portfolio Theory for Poets”. The book is aimed at “is aimed at the liberal-arts major seeking investment competence.”
The first chapter No Guts, No Glory (which addresses risk and reward) is online at his website.
If higher returns were guaranteed there would be no risk.
You’re right, Evidence. Now please go tell it to the Lindauerheads.
Please tell them that it goes beyond a question of higher returns being guaranteed. Do you know what the odds were of an investment in the S&P beating the 10-year return provided by TIPS back in 2000? About 1 in 10. It would indeed be fair to say that a dream with only a 10 percent chance of working out in the real world is something less than “guaranteed.”
Rob
If higher returns were guaranteed there would be no risk.
You’re right, Evidence. Now please go tell it to the Lindauerheads.
They know and have been preaching the “stocks are risky” gospel since the inception of the Vanguard Diehards board in 1998.
the best coverage that I have seen of the subject is in William Bernstein’s The Four Pillars of Investing
Your suggestion that those trying to learn more about these issues read Bernstein’s book is a good one, Evidence.
Bernstein takes both sides. He argues in Chapter One that investors are compensated for taking on added risk. Then he argues in Chapter Two that valuations affect long-term returns and that there are thus times when investors are not compensated for taking on added risk.
I think it would be fair to say that you are a Chapter One guy and that I am a Chapter Two guy.
Rob
They know and have been preaching the “stocks are risky” gospel since the inception of the Vanguard Diehards board in 1998.
They permit and encourage vague statements that “stocks are risky” because such vague statements present no threat to their advocacy of the Passive Investing gospel.
What investors need to know is how risky. For investors to protect themselves from the risks of stocks, they need to know when to lower their stock allocations and by how much. To know these things, they need to examine the historical data and what it tells us about the effect of valuations on long-term returns.
It was the community’s strong interest in discussing that topic that caused Mel to encourage his Goon Swuad to burn the Vanguard Diehards board to the ground.
Mel and the other Lindauerhards have no problem with the idea of saying the words “stocks are risky.” They have big problems indeed with the idea of permitting discussions of the steps that Rational Investors need to take to protect themselves from those risks when prices have reached the point where stocks have become a dangerously risky asset class for long-term middle-class investors to own.
It’s in the translation of the phrase “stocks are risky” into practical, valuable, actionable knowledge bits that the trouble arises.
Rob
Actually I am a Chapter One and a Chapter Two guy. Once you get beyond your rather simplistic view of investing you will understand that Chapter One and Two are compatible.
Chapter One is online so your readers can see for themselves that nowhere does Bernstein say that risk guarantees reward.
Chapter One is online so your readers can see for themselves that nowhere does Bernstein say that risk guarantees reward.
I’m grateful to you for providing the link, Evidence.
Rob
A key paragraph from Chapter One.
Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do from Wal-Mart. Think about it. If Kmart had the same expected return as Wal-Mart, no one would buy it! So its price falls to the point where its expected return exceeds Wal-Mart’s by a wide enough margin so that investors finally are induced to buy its shares. The key word here is expected, as opposed to guaranteed. Kmart has a higher expected return than Wal-Mart. But this because there is great risk that this may not happen.
I know that William Bernstein and others often imply that risk guarantees reward.
I have seen William Bernstein state the risk/reward trade off carelessly, implying that risk guarantees reward.
Have fun.
John Walter Russell
A key paragraph from Chapter One.
Bernstein calculated in the book the expected long-term return for stocks at 3.5 percent real (I think that number was too high, but it was better than the numbers most others were using). He reported that TIPS were paying 3.5 percent real with a government guarantee. TIPS are obviously less risky than stocks. So TIPS offered the far better long-term value proposition for investors at that time, according to Bernstein.
Why then does he throughout the book suggest that stock allocations of 60 percent, 70 percent or even 80 percent make sense? Why the heck would you want to have most of your money in stocks when you could obtain the same return from a zero-risk asset class?
The answer to this paradox is that Bernstein is a Passive Investing advocate. A key principle of Passive Investing is that stocks offer better long-term returns because they are more risky.
Bernstein says two opposite things because he cannot reconcile his understanding that valuations affect long-term returns with his advocacy of Passive Investing. The reality is that stocks generally offer the superior long-term value proposition but sometimes do not; it depends on the valuation level that applies.
Rob
I know that William Bernstein and others often imply that risk guarantees reward.
I would be interested to see the evidence for that. The quote I referenced above “The key word here is expected, as opposed to guaranteed.” outlines William Bernstein’s beliefs quite succinctly.
I used a life expectancy calculator to estimate how long either myself or my wife will live. It reported that there was a 50% chance one of us will still be around in 48 years and there is a 20% chance that one of us will survive for 55 years.
The Stock return predictor is currently reporting the most likely 50 year return for stocks as 5.63% real
TIPS are currently yielding less than 2%
I know which on makes more sense for my needs.
“The key word here is expected, as opposed to guaranteed.”
You’re the one who brought in the word “guaranteed,” Evidence. What I say in the blog entry is that Passive Investing enthusiasts say that taking on greater risk “always” leads to obtaining higher returns, not that higher returns are “guaranteed.”
I acknowledge that Passive Investing enthusiasts do not say that better returns are “guaranteed.” They usually have a footnote somewhere saying that there is no guarantee. But they do say that investors should stick with the reckless stock allocations advocated by the Passive Investing enthusiasts. And they do react with great hostility when people point out what the historical data says on this question. Why? Because it’s all a giant word game to them and the historical data is not taken in by word games.
There is no rational argument that can be put forward on behalf of Passive Investing. It is word games in the morning, word games in the afternoon, word games after supper time. It’s always been that way and it always will be that way. There are no rational arguments that can be put forward in support of a Ponzi scheme. And that’s what Passive Investing is. It works so long as there is a greater fool to buy your overpriced shares. When prices return to reasonable levels, the entire house of cards falls to the ground. When prices return to reasonable levels, all the greater fools are licking their wounds. Word games don’t pay the electric bill then.
Your argument reminds me of the one we often hear from “defenders” of the Greaney study. His study said that a 4 percent withdrawal was “100 percent safe” for retirements that began in 2000 and employed a 74 percent stock allocation. The historical data says that those retirements have only a 30 percent chance of surviving 30 years.
That’s a big problem. right? Hundreds of thousands of retirements are going to go bust in days to come as a result of these demonstrably false claims. So Greaney had the study corrected in 24 hours, right?
Not right. His “defenders” point out that he has language in a footnote somewhere saying that stocks may not perform in the future as they have in the past. That makes it A-OK that he gets the number so wildly wrong. So long as you have a caveat relating to an entirely different question, it’s perfectly fine to overstate the safe withdrawal rate by a full 2 percentage points and to thereby cause hundreds of thousands of people to suffer one of the worst life setbacks imaginable.
Um — right.
I will continue to report what the historical data says re SWRs accuraterly. I will continue to warn people about the irrationality of the Passive Investing approach. I will continue to point out the word games employed by those “defending” this approach. Call me madcap, but I have a funny feeling that millions of middle-class investors deserve a whole big bunch that what they have been getting from most of the big-name investing “experts” in recent years.
There are many spots on the internet where people discuss the word games used to “defend” the Passive Investing approach. This is a place for those who want to discuss the realities of long-term stock investing. I think it would be fair to say that we offer something very, very different. My sincere belief is that what we offer is a whole big bunch better. Each word game that I see put forward on behalf of this discredited “strategy” makes me feel that way all the more strongly.
Rob
The Stock return predictor is currently reporting the most likely 50 year return for stocks as 5.63% real. TIPS are currently yielding less than 2%. I know which one makes more sense for my needs.
I don’t agree with you re the strategy conclusion. But the facts you put forward are accurately stated.
Rob
What I say in the blog entry is that Passive Investing enthusiasts say that taking on greater risk “always” leads to obtaining higher returns,
You claim that but provide no evidence. Bernstein makes it clear that higher risks do not “always” lead to higher rewards.
You are the one playing word games Rob. I would be interested in the difference you see between “always” and “guaranteed”.
The Stock return predictor is currently reporting the most likely 50 year return for stocks as 5.63% real. TIPS are currently yielding less than 2%. I know which one makes more sense for my needs.
Somehow, I don’t believe that he will wait for 50 years before making withdrawals.
Have fun.
John Walter Russell
Somehow, I don’t believe that he will wait for 50 years before making withdrawals.
You are correct, however my portfolio may need to last over 50 years and hence that is what drives my planning.
I expect to start taking withdrawals in around 25 years time.
The 20 and 30 year figures from the Stock Return predictor are 3.48% and 5.65% real still well above what the real return on TIPS currently is.
Bernstein makes it clear that higher risks do not “always” lead to higher rewards.
Uh, good point, Evidence.
Um — Outstanding post!
Rob
I would be interested in the difference you see between “always” and “guaranteed”.
I am more interested in the difference between investing advice that destroys lives and investing advice that helps people come to an informed understanding of how stocks perform in the real world.
Rational Investing beats Passive Investing every time in my book, Evidence. The word games that are used to defend Passive Investing are just one of the many signs that point us to this conclusion.
You try cashing in word games to come up with the money to pay the electric bill when it gets cold outside. Please report back to us on how well that works out.
Rob
The 20 and 30 year figures from the Stock Return predictor are 3.48% and 5.65% real still well above what the real return on TIPS currently is.
Again, the numbers are accurate.
Rob
As your responses have now degenerated into non-responsive sarcastic remarks and red herrings I’ll take a break from this thread.
As your responses have now degenerated into non-responsive sarcastic remarks and red herrings
Goobula montami de sekonaught.
Mikindo morph pollie!
Sorkum?
(Just kidding around, Evidence.)
Rob