Those six words sum it all up. That claim is what The Great Safe Withdrawal Rate Debate has been all about.
The dominant investing theory of today — the Efficient Market Theory — says that it cannot be so. This theory posits that investing is a 100 percent rational endeavor. It makes no sense for safe investments to offer higher returns than risky investments. It is irrational. It cannot be. So says today’s dominant theory, a theory that has influenced 90 percent of what you have read about what to do with your savings for the past 25 years.
The Efficient Market Theory says that it cannot be so. What does The Stock-Return Predictor (a calculator that reports how stocks will perform in the future presuming that they perform in the future anything at all as they have always performed in the past) say? The Return Predictor tells us that at the top of the bubble (the P/E10 level was 44 in early 2000) the most likely 10-year annualized return for stocks was a negative 1 percent real. TIPS were at the time paying 4 percent real with a government guarantee attached. The safest investment in the world was paying five full percentage points more of return per year than stocks, which were at the time the riskiest an investment they have even been in U.S. history.
Safe investments can offer higher returns. That’s the reality.
The reality conflicts with the theory. What to do, what to do?
The “experts” say that we need to ditch reality, cover it up. Telling people the realities might undermine their confidence in the theory we all use to tell people what to do with their money.
Huh? Whazat?
Reality trumps theory. If the theory conflicts with reality, it is the theory that is wrong — the purpose of a theory is to describe reality accurately. We don’t dump reality. We dump the theory. So says Old Farmer Hocus.
Safe investments can offer higher returns. You would think judging by the reaction we have seen that telling people that is telling them bad news. It’s not, of course. It’s wonderful news. What could be better than learning that you can get higher returns by taking on less risk? That’s what we all should be seeking to do.
To get angry upon learning how to do it is to become a slave to theory, to put the desire to hang on to a discredited theory ahead of the desire to finance our retirements. Not this boy. No way, no how. I’m here to learn how to achieve financial freedom as early in life as possible. I love theories that help, I have no use for theories that hold me back.
Safe investments can offer higher returns. They usually do not, of course. The usual rule is that safe investments offer lower returns. But there are times when things are stood on their heads. How come? How do things get so messed-up? Why isn’t stock investing rational, as the theory insists it must be?
It’s because stocks are bought and sold by humans and humans ain’t rational. Perhaps you’ve noticed.
Take the humans out of the equation and perhaps we can bring that Efficient Market Theory back for another run. For so long as humans are permitted to own stocks, though, forget it. Assuming rationality in those circumstances is going off to live in an imaginary world. That’s not the smartest thing to do when putting together an investing strategy.
Here’s the kicker.
It’s only by acknowledging that human investors are irrational that humans can invest rationally. Holy irony, Batman!
There’s a fellow named Larry Swedroe (he’s written some investing books) who I mentioned this to over on the Vanguard Diehards board. His response was that, when stocks pay a lower return than normal, they are safer than normal. Stocks were paying the lowest expected return in history back in 2000, so it follows under Swedroe logic that stocks were the safest they have even been in those days. What do you say to something like that?
I said that it sounded to me that he was repeating back to us stuff he had read in books rather than using his intelligence (it is clear that Larry possesses a good bit of intelligence) to come to a rational understanding of the realities. He said that I was being “patronizing.” Again, what do you say?
Was I being patronizing? I feel that I was showing more respect for Larry’s intelligence than Larry himself was showing for Larry’s intelligence. Larry was putting forward words that made Larry sound like a fool. I know that Larry is not a fool. I was trying to lift Larry’s thought process to a higher place.
Safe investments can offer higher returns.
If you can accept that, you can learn how to invest rationally. Figure out why it is that safe investments sometimes offer higher returns than risky investments and you are well on your way to figuring out how stock investing works in the real world.
The alternative is to become a slave to a theory that has failed us.
I like theory as much as the next guy, probably more. But I only like theories that work. When I see that a theory does not explain reality at all well, I go off looking for another theory.
How about you?
Today’s Passion: One weekend I went to visit my mother in Philadelphia and didn’t bring my computer with me. I woke up early and was looking for something to do. So I pulled out my notebook and tried to come up with some reasons for sticking with a theory after it becomes obvious that it has failed. The work product of that morning’s effort is an article entitled Woody’s Allan’s Take on the Efficient Market Theory. The short version is that we believe that safe investments cannot offer higher returns because, well — we need the eggs.
Schroeder says
“Figure out why it is that safe investments sometimes offer higher returns than risky investments and you are well on your way to figuring out how stock investing works in the real world.”
I agree and the historical data will back this up. There have been times in the past when the 10-year return on stocks have been lower than bonds.
Here’s a question for you, Rob . . .
What is your 10-year forecast for returns on stocks and bonds? In other words, if I have $20,000 and put $10,000 in stocks and $10,000 in bonds, what is the most likely value I should have in stocks and the most likely value I should have in bonds 10 years from now?
Schroeder
Rob says
What is your 10-year forecast for returns on stocks and bonds?
I’ve never made a forecast and I doubt that there would be any value in what I put forward if I did make one, Schroeder. What difference could it make what some individual who posts on the internet says he thinks is going to happen? I mean, come on.
The Stock-Return Predictor reports what the historical data says about the possibilities for stocks purchased at today’s prices. You can use that to get a sense of the long-term value proposition of stocks and then compare that to the long-term value proposition of any of the alternate asset classes. Be sure to factor in the long-term gains you will obtain from being able to use money that you protect from loss by moving it out of stocks today to invest in stocks when they are at lower prices and offer a more appealing long-term value proposition.
Rob
John Walter Russell says
Your article highlights one of the worst things about the Efficient Market Hypothesis: the jargon.
Larry Swedroe was unable to escape the jargon. That got him to look at risk and reward backwards.
You should never accept a risk unless you are generously compensated for doing so. High risk, however, often means poor returns.
Have fun.
John Walter Russell
Rob says
Your article highlights one of the worst things about the Efficient Market Hypothesis: the jargon.
Boy, do I ever agree with this one.
Jargon is used to obfuscate. Those who possess a good understanding of the investing realities do not feel a need to resort to the use of jargon. When you know what you are talking about, you can state it clearly. Passive Investing enthusiasts always end up resorting to jargon sooner or later.
Many middle-class investors have a sense that the case for Passive Investing does not add up. But they hear the “Experts” using lots of big words and they are intimidated into thinking that they must be missing something, there must be something to this concept that they are just not quite able to grasp. The reality is just the opposite. The use of jargon by those pushing this idea is not a sign that they know more than those of us who have doubts for common-sense reasons but that they know less than those of us who have doubts for common-sense reasons.
The use of jargon is a bad sign. It’s a sign that you need to ask more questions, not that you should be intimidated into dropping the ones you started with. Those who are not able to respond to questioning with clear, sensible responses do not possess a firm grasp of the realities.
“Experts” who find themselves using jargon should return to the fundamentals and spend some effort figuring out where it is that they got on the wrong track.
Rob
LaughingAtRob says
First, ‘passive’ investing just means not picking stocks. What you seem to be ‘crusading’ against is ‘buy and hold’.
Unfortunately, it is a tough sell since buy and hold has done so well over long periods of time.
The ‘jargon’ aspect is hilarious since Rob himself does not understand what he is saying most of the time.
Rob says
First, ‘passive’ investing just means not picking stocks.
We are not in agreement re this, Laughing.
Your choice of a screen-name reveals to all reasonable people a lot about the Passive Investing mindset.
Where does this sort of hostility come from? It comes from trying to defend an idea that has no support in common sense or in the historical data.
The Passive Investing mindset not only does damage to your portfolio. It does damage to your soul.
Not this boy. I can’t go for that. No can do.
Rob