A Rich Life

The Old Ideas on Saving & Investing Don't Work -- Here's What Does

Podcast #75 — They Used Our Natural Risk Aversion Against Us

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I’ve added Podcast #75 to the “RobCasts” section of the site. It’s called They Used Our Natural Risk Aversion Against Us.

Behavioral Finance argues that we are excessively risk averse. So how did we get into this mess?

Comments

  1. I liked this a lot.

    I would stick with the term Rational Investing. If you use Probability Investing, engineers will drive you crazy trying to determine the mathematical details.

    Have fun.

    John Walter Russell

  2. I think you just stuck a knife in that one, John.

    That is an argument that persuades.

    Rob

  3. Rob,

    I like Valuation-Informed Investing (or even VII) because it more precisely states what the strategy is, absent any judgment that can be read into the word “Rational”.

    So for a book title (header and subheader):

    Title: Valuation-Informed Indexing
    Subtititle: A Rational Approach to Investing

    Now, if using “Rational Investing” as the title, you may well want to suggest in TITLE that there are other—irrational—investing modalities, and Rational Investing is snappier, but I wonder if I’d steer clear of that with the title and rather focus on the *identity* of the thing with the title. After all, you’d have plenty of space in a book to explicate the comparative stuff.

    And a subhead is almost always needed so you can use it as above.

    The toughest choice is often between “good” things. They both “work”.

    Arty

  4. Rob,

    “Plan B from Outer Space.”

    This should be a companion podcast to your “Science as Science Fiction.”

    Of course, it is suggested by Taylor that “Plan B” is pure Bogle because Bogle says someplace that if you can’t afford to lose another penny, get out of stocks. So, you see, it was always part of the plan and just another way of “staying the course”, which should not be confused with “buy and hold”. Got it?

    “Plan B” is anything you need it to be. It may not be “science” but sure wish I knew that when I was building my sailboat. But I’m no planner.

    So, as you see with your book titles, you have a “Plan A” and a “Plan B”. Just make sure you discuss both in the planning stage! 🙂

    Arty

  5. I like Valuation-Informed Investing (or even VII) because it more precisely states what the strategy is, absent any judgment that can be read into the word “Rational”.

    I agree with the point you are making here, Arty. However, I believe that the issue is a bit more complicated.

    The contrast with Valuation-Informed Indexing is Conventional/Passive Indexing. VII is a strategy.

    Rational Investing is something much bigger. Rational Investing is a model for understanding how stocks work.

    When I criticize Passive Investing, I am not criticizing any one particular strategy. I am criticizing the way of thinking that has produced just about all of the strategies we hear about today. All of these strategies are flawed because they are all rooted in the idea that it is not necessary to change one’s stock allocation in response to big price changes.

    So Momentum Investing has problems, Conventional Indexing has problems, stock picking has problems, Contrarian Investing has problems, even Value Investing has problems. The question of whether valuations affect long-term returns is so fundamental that, when you get that one wrong, you get it all wrong.

    I don’t like it that the term “Rational Investing” sounds argumentative. A title should be a description, not an argument. The term “Probability Investing” is more descriptive. The rational investor wants to have the probabilities on his side. That’s what the game is all about.

    The problem is that Passive Investing is so ingrained at this point that many investors (and many “experts” too) cannot even bear to hear about the probabilities. Passive Investing teaches that the probabilities are always the same, that valuations make no difference. Thus, when people hear the realities, they are shocked. Most people find it hard to accept how wildly off the mark the investing advice we have heard for 30 year is.

    So the debate today is between those who want to stick with the 100 percent emotional approach (the idea that valuations don’t matter is 100 percent emotional, no one has ever put forward a sliver of evidence in support of this idea) and those who want to know the realities. It is accurate to describe the model that rejects Passive Investing as Rational Investing. The key distinction is that Rationals are open to acknowledging the realities.

    I have come to the conclusion that there is no way to talk about investing intelligently and honestly without coming across as a bit argumentative. The idea of ignoring all the realities can fairly be described as insane. My way of dealing with this has been to acknowledge that the idea of investing passively is insane but to also point out as often as possible that there are many smart and good people who have endorsed Passive Investing. The ideas are insane, but the people are not.

    Passive Investing is not really a model for understanding stock investing. It is a model for avoiding the possibility of developing an accurate understanding of stock investing. The entire (unspoken) idea is to lend credence to the Get Rich Quick impulse, to block out consideration of what the entire history of stock investing tells us (that valuations affect long-term returns).

    The reason for all the friction is the shame that those who have advocated Passive feel for having caused so much human misery as the result of such a dumb mistake. There is of course nothing that can be done today about the mistakes that were made. I believe that we should be as charitable as we can possibly be while still being honest as well.

    We all need to work together as hard as we can to overcome Passive Investing. So we do indeed need to point out the wonderful things that can be done once we permit human reason to play a role in the development of investment strategies. In that sense, the term “Rational Investing” is the right one. It points to the primary distinction between the two models.

    The term should not be used as a means of ridiculing those who have advocated Passive. We need the Passives to help us develop the new model. We are all guilty of giving in to Get Rich Quick impulses. None of us are above the emotions that have caused millions to “believe” in the Passive idea.

    All Rationals are either former Passives or at least people who have at times felt a temptation to believe in Passive. And we are all capable at times of again falling victim to Passive thinking. Rational Investors are not 100 percent rational. No way, no how. Rational Investors are investors who have seen the damage done by adopting a Passive mindset and who are thus struggling to be Rational. We are not trying to cover up our earlier mistakes. We are trying to move forward.

    Anyone trying to learn more about investing is Rational. That’s by definition.

    Most of us are not pure Rationals or pure Passives. Most of us are a mix. There are millions of non-dogmatic investors who follow Passive thinking in some decisions and Rational thinking in other decisions. Only the true dogmatics can be said to be 100 percent Passive. Those are the ones who feel most threatened by discussion of the realities of safe withdrawal rates and all the other topics that come up in reasoned discussions of investing.

    Rob

  6. So, you see, it was always part of the plan and just another way of “staying the course”, which should not be confused with “buy and hold”. Got it?

    The Plan B stuff is very sad.

    Taylor is capable of making constructive contributions if he gets over his pride and acknowledges that he has made mistakes. We have all made mistakes. It shouldn’t be such a big deal for us all to admit them.

    Taylor would move things forward in a wonderful way if he put up a post describing when and how he learned that Passive Investing does not work. All of us would learn important stuff from such a post and from the thread that would follow from it.

    Instead he makes the entire community look like total idiots with this “Plan B” stuff. That gibberish makes Taylor Larimore look like an idiot while also making John Bogle look like an idiot while also making everybody who has ever valued the advice of Taylor Larimore and John Bogle look like an idiot.

    We’re not idiots. We’re capable of better. A lot better.

    Rob

  7. Rob,

    Listening to this podcast I’m actually blowing coffee out my nose laughing. It is funny even as its ramifications are sad. I suppose the funny thing is *how* you say things with your sacrcasm and tone. Maybe its just the way my humor runs…

    This podcast, and the other one, reminds me of a 1980s song, “She Blinded Me with Science”. That is exactly what happens. I know this because I’m in a field (exercise science) in which the exact same usages and outcomes happen. Science is often used as a “robe” to cloak the “high priest” (expert). Sadly, if and when this is discovered, the first response by many is to become anti-science. Thus, good tools can then be thrown away (ref. the story about the hand-gold-digger given a shovel).

    But nothing is wrong with science, per se. It is how we fail science or misuse use it that is the problem. There are several questions we should ask whenever a study is cited as support for some modality. Here are just a few I ask:

    •What does the particular study *actually* show or *actually* measure?

    •What of it?

    •Does the author’s own data actually support his stated conclusions?

    •Is it a good study or a bad one? Does the author misuse the very references he cites to support his bias, or does he use them accurately to support an argument?

    •How does what is actually shown and supported relate—or not realate—to what another “expert” says the study shows?

    Now, because I am trained in this, I can read studies beyond the abstract and conclusion (which very few readers do—if that) and suss this stuff out.

    The broad problem is this. Most people lack the time, or the ability, or desire, to do any of this. So they let the experts explicate it for them. The high priests then appear, robed in science, to give us “the word”. Then, depending on the skill and ethics of the expert, we may be back to the beginning–blinded by science.
    —

    I like very much what you say about how we have been fed that not investing in stocks is the real risk (and it can be riskier than cash-sitting in *some* comparative circumstances) But the *misapplication* of the context in which it may be correct, then influences investors to make bad choices at the worst times.

    —

    Back to your titles, I’m thinking that “risk management” (what you mention in the podcast) is really what is being done with VII (thus, the “rational” component). And maybe that is a good *direction* to incorporate in a title or subtitle.

    Arty

  8. I’m actually blowing coffee out my nose laughing. It is funny even as its ramifications are sad.

    There’s nothing that makes me happier than to hear people tell me that the the podcasts make me laugh. The problem is pomposity and arrogance and know-it-all-ism. The solution is jokes and song lyrics and true-to-life stories. This is a case in which humor really is the best medicine. The most important lesson that the “experts” need to learn is not to take themselves and their pronouncements so seriously.

    I suppose the funny thing is *how* you say things with your sacrcasm and tone.

    Sarcasm is my least favorite rhetorical device. I acknowledge that I have employed it at times in my discussions of the harm done by Passive Investing because the realities are so far over the top that I don’t think there is any way to capture them in words without some sarcasm. I hope that my words never come across as a nasty sarcasm.

    My aim is to ridicule the idea that valuations do not affect long-term returns while also reaching out to the millions of good and smart people who have fallen for the Passive Investing nonsense in a spirit of warmth and charity and friendship and respect and love.

    My tone is often one of understatement. Understatement is my favorite rhetorical device.

    Rob

  9. Science is often used as a “robe” to cloak the “high priest” (expert). Sadly, if and when this is discovered, the first response by many is to become anti-science.

    This is exactly it, Arty.

    When discussions of safe withdrawal rates come up nowadays, people become embarrassed. They say “Couldn’t we just talk about something else?”

    The idea is — The Old School SWR studies failed us and therefore we should never again use SWR studies to plan our retirements.

    No!

    Accurate SWR studies are a huge plus.

    SWR analysis is a wonderful thing. All of our problems stem from getting all the numbers so wildly wrong. We got the numbers wildly wrong because we believed in Passive Investing. Take out the Passive Investing part, and SWR analysis is a boon.

    Rob

  10. Most people lack the time, or the ability, or desire, to do any of this. So they let the experts explicate it for them.

    Again, you’ve hit it exactly on the head.

    “Expertise” in this field should mean talking us out of Passive Investing, not talking us into it. Those who talk us into it are “expert” at selling stocks at insanely high prices, nothing else.

    I don’t mean that as a dig. Lots of the people who promote Passive Investing have offered powerful insights at times when they were not promoting Passive Investing. My aim is to help these people become true experts. For that to happen, we need to change our ideas about the goal of the investing project. The goal should be to help people achieve financial freedom sooner.

    When you think about it that way, you see the need to correct retirements studies that get all the numbers wrong.

    What I am saying here should not be even a tiny bit “Controversial.” The fact that during the Passive Investing Era it became controversial as all get-out tells us just how deep the problems go. The problems are of a fundamental nature.

    The biggest problem is that most of today’s investing “experts” don’t understand the ABCs. We need to start with recognition of that frightening reality and then move forward step by step from there.

    Rob

  11. I’m thinking that “risk management” (what you mention in the podcast) is really what is being done with VII (thus, the “rational” component).

    You’re right that it’s all about risk management. That’s another key topic re which the conventional advice gets it all wrong.

    I’ve recorded (but not yet posted) a podcast called “The Equity Risk Premium Explained At Last! (Perhaps)”. It’s a sick joke that some guy whose only “expertise” is that he has figured out how to post stuff on the internet can record a podcast giving new answers to questions that have baffled the “experts” for years now.

    How did I manage to do such a thing? I started from a different premise. I started from the premise that what our common sense tells us must be so might actually be so, valuations might actually affect long-term returns. When you start from a premise that makes sense, all sorts of wonderful things become possible.

    When the “experts” permit themselves to consider the possibility of employing some common sense in their investing analysis too, there will be no stopping them. They are smart and good people crippled by a “belief” in Passive Investing.

    Risk matters. It’s a biggie. And for the past 30 years we haven’t been able to learn much useful about it because it has been taboo to mention the reality that valuations affect long-term returns and all investing strategies must take that reality into account to have any realistic hope of working in the real world.

    Rob

  12. Rob,

    Listening to this podcast again…

    You’ve mentioned that because stock prices may increase during high valuations, it makes sense always to have something in stocks, even as little as 20%. Makes sense to me. Greatly limits downside loss yet allows participation in upside.

    But the reverse condition must also be true. Stocks are quite fairly valued right now, yet we might suffer three more down years. Just as stocks went up from ’95-’99, when they were began at a time of irrational exuberance, they could get hammered now. So, what does one do? If you are in 60% or more right now (as present valuations might suggest is appropriate), an investor would get crushed, and maybe capitulate, with the *consecutive* down years (as you mentioned when you discussed “maximum tolerable loss” points that many experts use to assess investor risk tolerance).

    I suppose I should first ask from a valuations perspective, are both sets of possibilities equally probable, as ’95-’99 suggests with one direction? If so, informed with long-term valuation info, and using the tool, what’s a reasonable strategy we can use to respect both sets of possibilities? Consider this in light of the belief that we are indeed risk averse. This suggests the average “risk averse” investor needs to guard more against downside loss than to exploit upside gain? If so, perhaps P/E 10 valuations would need be very low (single digits) to entice an investor such as this into even the 60% category—as a maximum! Of course I know that individuals are just that and these “rules” are subject to their particulars. But one needs to consider both sets of possibilities: irrational exuberance and irrational depression.

    Arty

  13. Consider this in light of the belief that we are indeed risk averse. This suggests the average “risk averse” investor needs to guard more against downside loss than to exploit upside gain?

    That’s a fantastic point, Arty.

    There’s a live possibility that we are going to see another 50 percent drop from here. It could be another five years before stocks do well. If dark scenarios play out, the media is going to be playing on our fears. We are naturally risk-averse. All of these factors add up to — go with a low stock allocation.

    The other reality is that a P/E10 of 12 is a great P/E10 level. Stocks offer a fantastic long-term value proposition at today’s prices. And it is also totally possible that we will not see any of the bad stuff outlined above. We might stabilize at today’s P/E10 level. If we stay in this general neighborhood for five years , you want to be heavily in stocks for those five years. You would be earning 6 percent real per year if we stabilized. You could hurt yourself in a serious way by waiting to get back into stocks.

    Passive Investing is not just an investment strategy, it’s a way of thinking about stocks. Rational Investors are not even speaking the same language. It’s a totally different head.

    I believe that Passives should be at zero stocks until they recover from the disease that led them to believe for a time that engaging in long-term timing is not required. Some are going to view that statement as “extreme.” The reality is extreme. Passive Investing is a bad, bad business. It cripples investors. It makes it impossible for them even to give serious consideration to the rational way to invest.

    I believe that Rationals should not wait to invest in stocks. The numbers are too good today to be totally out. It makes sense not to be totally in. Another big price drop is a live possibility. Those not able to deal with that emotionally should not be in stocks. But those who are emotionally prepared for a 50 percent drop are taking a serious risk to be totally out of stocks today, in my view.

    My take is that the circumstances that apply (both on the numbers side and on the emotions side) justify in the typical case a stock allocation of around 50 percent or 60 percent (personal circumstances always need to be taken into account, to be sure). But I think it’s worth noting that Shiller is staying out of stocks until the P/E10 level drops below 10. I don’t agree with Shiller re this but I sure do respect his intelligence.

    There are no final “right” answers. The numbers inform us. They guide us. They cannot be used as definitive instruction. Those who try to use them that way are making a mistake. I am confident that that is so.

    The real problem here is that we are not accustomed to studying the emotional questions. The emotional questions are 70 percent of the game. And we barely know how to begin going about taking them into account.

    If Rational Investing becomes the dominant model, we will become better at this with time. We cannot rush the process. We do not know everything today. Our state of knowledge is primitive today. The best thing to do is to acknowledge that and not give in to the temptation to fake confidence in our pronouncements as a means of quelling our fears.

    We do not know it all, we do not know it all, we do not know it all.

    The emotional reality is to accept that that is so. Pretending otherwise just makes things worse. Pretending otherwise leads to defensiveness and anger and fear and all sorts of bad stuff. It is giving in to the natural human urge to quell legitimate fears re investing that got the Passives so messed up.

    We do not know it all, we do not know it all, we do not know it all.

    P/E10 is a great P/E10 level. Stocks offer a great long-term value proposition. We know that much.

    But we are humans and we do not know a great deal about how humans should best take advantage of that knowledge in the sorts of circumstances that apply today.

    The thing to do is to start trying to learn. We should start permitting ourselves to talk about the realities.

    Just doing that will make us all feel a bit better, I believe. I view it as unnatural to prohibit discussion of the realities. I believe that the ban on honest posting just makes us all more afraid.

    Once we start talking about it and once we learn to accept that some fears really are justified, I think we will be able to see that it’s not as bad as it seems at the moment. It seems worse than it is at the moment because we have been letting our fears rule us for a long time and we know it and that knowledge unsettles us. We can change that. We have the power.

    We need to come to trust ourselves enough to permit ourselves to talk about the realities. That’s a big step.

    We should pay less attention to the question “What should my allocation be?” There’s no good answer to that question until we give our answer to the more important one — Do we care enough about the future of our nation to take action to open up the possibility of honest discussion of the investing realities? That’s the one that really matters.

    If we give the right answer to that one, I think it will all work out in the end. Why wouldn’t it?

    If we give the wrong answer to that one, I think it is fair to say that we are pretty much doomed regardless of what stock allocation we go with. So what does it matter really?

    People are thinking about this from the standpoint of self-interest. What should I do? What is best for me? I, me, me, mine. No!

    We save our individual selves by saving our economy and our political system. That’s where the focus should be for the time-being. The stock-allocation stuff will work itself out once we gain the courage to do something to save our economic system and our form of government. People are focused too much on the micro and have lost sight of the importance of the macro.

    Rob

  14. “If we stay in this general neighborhood for five years , you want to be heavily in stocks for those five years. You would be earning 6 percent real per year if we stabilized. You could hurt yourself in a serious way by waiting to get back into stocks….

    I believe that Passives should be at zero stocks until they recover from the disease that led them to believe for a time that engaging in long-term timing is not required. Some are going to view that statement as “extreme.” …

    I believe that Rationals should not wait to invest in stocks. The numbers are too good today to be totally out.”

    I agree with all that in full. Save for the recovering ones who might need to be “deprogrammed,” I would not be out of as stocks today just as I would not have been out in ’95-’99. Prudent strategy means “staying in the game,” unless of course, other—individual—circumstances dictate otherwise. What I am suggesting is that we acknowledge that there is still possibility of continued steep decline (we both agree) just as there was a big advance post ’95. But there may be a better way to prepare for this so that a “Plan B” never has to be instituted—even for a VIIer.

    It really means, for me, that I would wait for Shiller’s drop-point before I was 60% in (P/E 10). Of course, I’d still be in equities right now, but not 60% (maybe 40% with value tilts, perhaps), Indeed, I might never go higher than 60% equities, just as I might never drop lower than 20% equities. For me, and for others who are risk averse (most investors, according to Swedroe et al, and I think, you too agree on that) this means the strategic stated objective (the Prime Directive, in “Startrek” terms) must be *always* first to protect against downside loss *more* than positioning for upside gain. Never sit out of equities, but change your *dispersion of returns curve* by rarely going high on beta risk (60% is high, in this philosophy). That way you really stack the odds in your favor. Maybe you’ll not make the most possible, but boy, do you guard against losing it. That is what you’ve been saying all along. What good is hoping to make a lot in 4 years (96-99) if you thereafter get crushed—statistically *and* emotionally?

    And your “5-year neighborhood” 40% equities (coupled with high-quality fixed income) will do quite nicely if valuations and equity returns favor. Another reason I say that is this. VII is about looking at entire market cycles—from peak to trough. So, done properly, while you may participate with only 40% in high-returning equities, you already saved yourself a tone by not getting crushed in the first place! And, I might add, the 40% participation in a strong market turnaround is like participating with a much higher equity allocation with less of an advance; thus, higher expected returns means you can do well with fewer equities, and less risk. VII can be used beautifully, but an investor should consider the *full market cycle* and the reality of the almost universal (behavioral) risk aversion. The two dictate proper action. So, I shape my curve differently, and my equity participation in accordance with that curve.

    Thus, while I recognize that VII has 2 components (when to invest less, and when to invest more, in equities), the truly compelling part of your numbers argument (Shiller’s work too) is the doomsday scenario (which has now occurred twice in 10 years). *That* is what got me interested 2 years ago when I first read about it. And it remains so—ever more—today.

    Buffett’s first law is: “first, don’t lose.” Stated more realistically, “first, protect against downside loss,” while still being in “the game”. Respecting Valuations within the framework of natural risk aversion allows you do do this. But emotionally, downside loss is *felt* more acutely than upside gain. So it also addresses your behavioral component, which seems to be the biggest part of your position.

    Arty

  15. an investor should consider the *full market cycle* and the reality of the almost universal (behavioral) risk aversion. The two dictate proper action. So, I shape my curve differently, and my equity participation in accordance with that curve.

    I think you make great points, Arty.

    I am personally inclined to go with a higher stock allocation when prices are reasonable. One of the things I like about lowering my stock allocation when risk is sky-high is that it permits me to invest more heavily in stocks when the return is better without taking on additional risk on an overall basis. But I think that what you are saying also makes great sense.

    You are right that we are naturally risk averse and that this reality is given too little consideration in most stock analysis. So I am grateful that you are adding a perspective that I am not able to offer but that a good number of community members should be taking into consideration.

    This is the stuff that people need to be talking about. This is the real thing.

    Rob

  16. Rob,

    The insight regarding shaping the potential dispersion of returns comes from Larry Swedroe, and his observations regarding massive risk aversion. It is one way he applies the findings of Harry Markowitz (looking at portfolios as a whole), who won a nobel prize for that.

    VII requires shifting allocations. It makes sense in the whys and hows of it. And there can be multiple implementations of it—mine being more risk averse than yours, say, but both responding to valuations with allocation shifts; for all I know, our two VII approaches would produce similar long-term returns, even as the swings in returns (dispersion) would vary to reflect our differing beta exposures during certain *portions* of market cycles.

    Harry Browne went after the problem differently, while respecting the primacy of risk aversion. As you know, his approach does not require allocation shifting because it uses a “permanent portfolio” that responds to the differing economic climates, as he defines them. His 37-year record for accomplishing his stated goal, through multiple market cycles, is remarkable—the portfolio simply *never* got crushed. The worst loss was about 4 or 6% depending on which indexes you used. This includes the current bear (it gained 1% in 2008!) and the distant inflationary hoopla of the 70s that murdered many.

    The advantage of a method that does not require shifting allocations—providing it actually works— is that you never have to make “guesstimations” relative to valuations.

    Now, there is another approach that might work, but it requires looking into equity asset classes. Again, Larry is the only person to advocate this extreme approach and, for sure, he has received heaps of criticism from Boglehead traditionalists. It involves using about only a 30% exposure to the riskiest equity classes that have the greatest return potential (small value, international small value, emerging markets) and 70% to the safest instruments you can find (TIPS or ST Treasuries or CDS, as valuations/yields for these dictate). Here’s what happens in his words:

    A) The portfolio outperforms and then you are ahead.

    B) The portfolio underperforms but markets are up overall–you win again because your goal was to cut the left tail risk and you knew ahead of time that the trade off was that you would give up some upside potential.

    C) The portfolio underperforms but markets go down (like now). Now you are highly likely to outperform–lose less–because beta (equities) is more volatile than the other risk premiums. So you win again.

    Thus you convert the “game” into a win but don’t lose in almost all scenarios—trading off some upside potential.

    Rob, I know that getting into Small and Value asset classes is not your cup of tea. You simplified things with the S&P and shifting allocation to address valuations. But HB, and maybe Larry have accomplished what you have by *not shifting* (but by no way resembling the unshifting mainstream portfolio model). Thus, the results of HB, Larry, and VII might be similar over the long term. And a stated objective of all is similar—protect against big losses, first.

    Again, I am not recommending an approach here—Larry’s or Harry’s. I mention these only to examine what they all may hold in common, and therefore understand why they may all work. It may be that each approach, seemingly very different, shares in common a powerful risk management tool: shaping the potential dispersion of returns.

    Arty

  17. The insight regarding shaping the potential dispersion of returns comes from Larry Swedroe

    I wish that we could persuade Larry to speak out more strongly in opposition to Passive. He has a lot of good ideas and I would like to see them explored in more depth in civil and rational discussions.

    Rob

  18. for all I know, our two VII approaches would produce similar long-term returns,

    We’ll be able to check this from a number standpoint when The Investment Strategy Tester becomes available, Arty. I expect that to be within a week or so.

    Knowing the numbers is only knowing half the story, of course. The best strategy is the one that works best. The strategy that works best on a numbers basis is not necessarily the one that works best for a particular investor.

    Rob

  19. The advantage of a method that does not require shifting allocations—providing it actually works— is that you never have to make “guesstimations” relative to valuations.

    I agree.

    I see great theoretical appeal in the Harry Browne approach.

    Rob

  20. Larry is the only person to advocate this extreme approach and, for sure, he has received heaps of criticism from Boglehead traditionalists.

    Why are these words causing me to want to root for Larry’s idea?

    I’m just joking around.

    Rob

  21. It involves using about only a 30% exposure to the riskiest equity classes that have the greatest return potential (small value, international small value, emerging markets) and 70% to the safest instruments you can find (TIPS or ST Treasuries or CDS, as valuations/yields for these dictate).

    This sounds worthy of exploration, in my view.

    It sounds like it is probably too sophisticated for the typical middle-class investor, however.

    One thing I would be careful about. Larry tends to believe that risk is always rewarded. I don’t think that’s right. Just because an asset class is high risk does not mean that it is going to provide high returns.

    Still, the concept makes sense (in my assessment).

    Rob

  22. It may be that each approach, seemingly very different, shares in common a powerful risk management tool: shaping the potential dispersion of returns.

    I agree with you, Arty. I think you are raising very helpful points.

    Please don’t think that I am saying that Valuation-Informed Indexing is the best way to go or the way to go for everyone or anything like that. I don’t believe that is so.

    The claim that I make is that VII must beat Passive Indexing on a risk-adjusted basis in the long term.

    I’m more a guy who is against something than someone who is for something. I am against Passive.

    The way that this happened is that I reported the safe withdrawal rate accurately and the roof fell in on our entire community. I took some time to figure out what that was all about. It turned out that the problem is Passive Investing. Passive doesn’t make sense. So, when people buy into it, they become defensive. That leads to a host of problems down the line.

    There are all sorts of things that can work. I think you are suggesting good options.

    My purpose in exploring VII in depth is to show people that it is easy to beat Passive. VII is as simple as Passive Indexing. So it is easy for people to understand the comparisons. It would make perfect sense for people to shift from Passive Indexing to Valuation-Informed Indexing and then over time to something more sophisticated.

    VII is NOT the end point. The goal of presenting the case for VII is to get people out of the rut of thinking that Passive might work. Once people get beyond Passive, there are all sorts of wonderful opportunities that open up to us.

    I view Passive as a bad idea that sucks all the oxygen out of the room. There is no other “strategy” that I have ever seen that inspires so much dogmatism and so much anger and so much self-destructiveness and so much hate. Passive is very, very bad news.

    Lots of people are capable of coming up with lots of good ideas once we clear the air by burying the Passive dogmatism 10 feet in the ground. I have no worries on that score.

    VII is just one post-Passive option. Nothing more, nothing less.

    Rob

  23. “It sounds like it is probably too sophisticated for the typical middle-class investor, however.

    One thing I would be careful about. Larry tends to believe that risk is always rewarded. I don’t think that’s right. Just because an asset class is high risk does not mean that it is going to provide high returns.”

    I think Larry would agree with both your statements. I should have added that he always says that his recommendation is not for everyone—just the very informed (educated) investor. Mainly, this is due to the *tracking error regret* an investor might have (when his portfolio does not follow the broad market). By contrast, VII has no tracking error regret, per se, regrading its allocation, because VII is “the market”.

    And Larry is just working off how the markets have performed historically (higher risk has led to higher return). But he always uses the adjectival “expected* with the notion that it might not turn out this way; he *does* say that also.
    —

    “Knowing the numbers is only knowing half the story, of course. The best strategy is the one that works best. The strategy that works best on a numbers basis is not necessarily the one that works best for a particular investor.”

    Absolutely. You sound like Larry when he says, “there is no right portfolio, only a portfolio that is right for you”.

    Hey, maybe you should get him on an interview podcast like they do at Merriman and other places. Maybe get others too, once in a while. Interviews add lots of interest and do relieve the burden a bit. Frankly, I don’t know how you produce so many podcasts at those lengths…

    Arty

  24. Larry is just working off how the markets have performed historically (higher risk has led to higher return).

    We don’t agree re this one.

    The historical record shows numerous cases in which the risk premium was very slight or even a negative number (cases in which the long-term return for the riskier asset class was less than the long-term return for the less risky asset class).

    The idea that risk is rewarded with a higher return is of course generally true. This is certainly the way it should be.

    The reason why it is not always the way it should be is that investors are often not rational. Investors should demand a risk premium when they invest in risky asset classes. But there are times when they are willing to accept lower returns for riskier assets. There is no law of the universe that forces investors to demand a risk premium. It is up to them.

    Larry is going by theory when he says that risk is always rewarded, not data. This is one of the claims that results from a belief in the Efficient Market Theory. The Efficient Market Theory is an assumption. It is not supported by the historical record.

    Rob

  25. Hey, maybe you should get him on an interview podcast like they do at Merriman and other places. Maybe get others too, once in a while.

    That’s a great idea. I don’t today know what buttons I would need to push to make something like that happen. But I could make it my business to find out somewhere down the line. I love the idea.

    Larry is someone who I would like to talk with more about all this stuff. I don’t know if the feeling is mutual or not. We had some good interactions at Vanguard Diehards. But there was a time or two when I got the sense that he was none too happy about some of the points I made and about some of the questions I asked him. I don’t believe that he has ever spoken up there in a strong way in opposition to the ban on honest posting on safe withdrawal rates and other valuation-related topics.

    I’m certainly willing to give the idea a shot, however. It would be a great learning experience for everyone.

    Rob

  26. I don’t know how you produce so many podcasts at those lengths…

    It’s taken me years to come to a fairly good understanding of the implications of our finding that valuations affect long-term returns (and I am confident that my understanding is not anything close to being complete even today). This changes everything. I’m not joking when I say that 70 percent of the investing project (the valuations/emotions part of the story) has been all but ignored until now.

    I often don’t even write down ideas for new articles or podcasts anymore because I have so many listed already that I am never going to be able to get to them all. This one change is so fundamental that it changes everything. The insights just develop on their own. All that the confirmed Rational Investor needs to do is to be willing to reach down and pick a few up every now and again.

    We’ve got a tiger by the tail, Arty. I’m sure of it!

    Rob

  27. “The historical record shows numerous cases in which the risk premium was even very slight or even a negative number (cases in which the long-term return for the riskier asset class was less than the long-term return for the less risky asset class).”

    Larry would agree. He mentions late ’90s, as the example.

    “The idea that risk is rewarded with a higher return is of course generally true. This is certainly the way it should be.”

    *My* sense is that he operates off this assumption except for periods of *extreme* valuations.

    I think he sees a large “middle ground” where equities roam normally, fairly priced. (Even by VII standards, that is not unreasonable.) However, in TIPS valuations, he finds the 10-year TIPS roam within a 1-4% yield—a much tighter band than equities. I think you’d find each of you embrace some portion of “the truth,” with perhaps significant differences on how you interpret and apply certain principles.

    In my opinion….he sees himself as a passive investor, but clearly respects valuations. He may shift out of the Growth/Blend class (high valuations in late ’90s) but into Value (low valuations in late ’90s). He thinks the markets are mostly efficient—insofar as the inefficiencies are not exploitable—certainly not day-to-day timing. Now, was his altering his equity allocation in the late 90s an exploitation of an obvious inefficiency? His words are, of course, better than my observations and direct communication will tell a lot. You guys would need to talk to see what is *actually* said and in what context.

    Overall, he has stunned some of the “conventionals” with his extreme-tilt portfolio and mention of valuations, and his knowledge is sought after by many, especially regarding fixed income (TIPS), where he uses valuations a lot. Of course, these days, the conventionals are not chirping so much about buy and hold/passive, and frankly, he was never powerfully challenged on those points, from what I read.

    Arty

  28. Larry would agree. He mentions late ’90s, as the example.

    You’re right that Larry often points out that valuations affect long-term returns. He’s very strong on this point.

    Where I find fault with Larry is that he does not speak out strongly in opposition to Passive Investing and the Efficient Market Theory. If valuations affect long-term returns, the market is not efficient (in an efficient market, significant amounts of overvaluation and undervaluation are logical impossibilities) and Passive Investing cannot work. When asked about these matters, Larry gives answers pulled from the text books (that is, wrong answers). I’ve personally been involved in discussions in which he has done this.

    When I pointed out that his answers did not make logical sense, he said that I was being “patronizing.”

    Rob

  29. *My* sense is that he operates off this assumption except for periods of *extreme* valuations.

    I think he sees a large “middle ground” where equities roam normally, fairly priced. (Even by VII standards, that is not unreasonable.)

    You are raising an important point here, Arty. I am in strong disagreement with the suggestion that is being put forward (it’s Larry putting it forward, not you, but you are not objecting in strong terms to the “idea” he is putting forward).

    You are describing Larry’s views accurately. He says that valuations matter. But he suggests that they matter only when they are extreme. It is very important that people understand why such an argument is dangerous and destructive to middle-class wealth.

    It is true that in practical terms valuations don’t matter except at the extremes. The tools we use to tell people when to change their stock allocations are not precise enough to permit us to give helpful advice re this point except when valuations reach extreme levels. The value proposition from stocks is generally so strong that it does not pay to make allocation changes in response to small changes in price.

    It does not follow that the Efficient Market Theory is valid or that Passive can work or that valuations do not always affect long-term returns. To believe that there can ever be a circumstance in which valuations do not affect long-term returns is to give up the use of human reason. Once large numbers of investors give up the use of human reason in the development of their investment strategies, the economy is doomed. It is the prohibition on the use of human reason in the planning of investment strategies during the Passive Investing Era that has caused all our problems.

    Investors need to be told the realities of stock investing. They need to be told that valuations always affect long-term returns, that the market is never efficient, that thinking in Passive terms is always suicide.

    This is where Larry goes off the rails. The error he makes on this point leads to all other sorts of errors down the road.

    Larry argues that stocks were the safest they have ever been in history in January 2000. Why does he say such an insane thing? Because he believes BOTH that valuations matter AND that the market is efficient. He knows that valuations were the worst they have ever been in January 2000. Thus, he knows that the likely long-term return was the worst it has ever been in January 2000. So he logically should have been telling people to go with low stock allocations in January 2000.

    But a believer in the Efficent Market Theory and Passive Investing cannot say such words. A believer in the Efficient Market Theory and Passive Investing cannot admit that there can ever be a time when stocks offer a worse long-term value proposition than a money market account — that is a 100 percent irrational reality. So how does Larry explain the reality that existed in January 2000.

    He tells himself that the risk of stocks must have been less than the risk of money markets. This is an insane idea. But Larry says it and I believe that Larry believes it. His belief in the Efficient Market Theory has rendered him incapable of employing logic and reason in his analysis of how stock investing works. I don’t say that to hit on Larry, I say it because it is the only coherent explanation of the realities available to me.

    Valuations ALWAYS affect long-term returns. The market is NEVER efficient. Passive cannot possibly work in the long term.

    These are the realities that we need to be teaching all middle-class investors. You can’t tell people that valuations have no effect except every once in a while and expect the message to stick. That message makes no sense. People cannot believe it. Tell people that valuations don’t matter except at the extremes and people will engage in massive amounts of rationalization to persuade themselves that prices are not extreme at times when they are extreme. People are not capable of changing their entire belief system just because the P/E10 level happens to go up a few points. This “idea” can never work in the real world.

    The reality is that valuations ALWAYS matter. It’s not always necessary to make changes in one’s stock allocation in response to price changes. But valuations ALWAYS matter. That point needs to be drilled home again and again and again. There ain’t no efficient market. The efficient market is 100 percent myth. The efficient market “idea” is the thing that has caused all our troubles.

    Larry is a smart guy. But Larry is WRONG re this one.

    Rob

  30. I think you’d find each of you embrace some portion of “the truth,” with perhaps significant differences on how you interpret and apply certain principles.

    I’m perfectly happy to say that Larry is a smart and good person. I believe those things.

    I am not able in conscience not to point out the things that he has gotten terribly wrong. Larry’s errors have caused great human misery to those who have listened to his investing advice. There are responsibilities that go with offering investing advice and Larry has failed to meet these responsibilities on some occasions. That’s just the way it is.

    I don’t fault him for making mistakes. All of us make mistakes. That’s all just part of the wonderful game.

    I fault Larry for tuning out discussion of his mistakes. He gets huffy when his mistakes are pointed out to him. I have participated in threads in which I have seen this, so I know this to be so.

    It’s not entirely Larry’s fault. The usual procedure in such situations is that a person’s friends step forward and try to help the person acknowledge the facts of life. None of us are naturally inclined to admit our mistakes. Sometimes we need a little push in the right direction.

    InvestoWorld operates by a different set of rules. In InvestoWorld, “friends” of “experts” seem to see it as their job to “protect” the person from having to acknowledge mistakes. We have seen this over and over and over again over the course of the first seven years of discussions. Larry makes it clear that he does not want to acknowledge his mistakes and a group of pro-Larry goons steps in and puts honest posting on the question to an end.

    This hurts Larry. This hurts the Goons. This hurts all the other “experts.” This hurts you. This hurts me. This hurts every single community member.

    But it continues to go on on a daily basis everywhere I look to check. It will stop when our pain grows so great that the thought of not fixing the mistakes we have made becomes more horrible to us than the thought of fixing them. Things have to reach a point where the idea of saying the three magic words is in relative terms not so distasteful a thought any more.

    Once we work up the courage to say the three magic words (and to help others to do so), it’s over. That’s when we turn around and start walking in the right direction again and regain confidence in the markets, in our “leaders,” and in ourselves.

    I allow myself to entertain hopes that we are getting close. But I’ve been wrong in my optimistic takes before. We’ll just have to wait and see what happens.

    Rob

  31. In my opinion….he sees himself as a passive investor, but clearly respects valuations.

    That’s exactly right.

    It’s also 100 percent nonsense.

    The same human mind cannot both respect valuations and also favor Passive Investing. Passive don’t change their stock allocations in response to changes in valuations. That’s the thing they are being passive about!

    The Passive Investing idea is the idea that you don’t need to change your stock allocation in response to price changes. That’s what it is! You can’t say that you believe in Passive but you don’t believe in what Passive teaches and still retain your rationality.

    This is why I say that Rational Investing is the opposite of Passive Investing. Rationals don’t say that there is no need to change one’s stock allocation in response to price changes. Rationals are open to understanding the realities of stock investing that Passives deny.

    Rob

  32. He thinks the markets are mostly efficient—insofar as the inefficiencies are not exploitable

    You’re now talking gibberish, Arty. I mean no personal offense. I love the contributions you put forward. You’re as smart as smart can be. But you are here talking gibberish. If you don’t see it, I think it is my job to help you see it.

    The most likely long-term return on stocks in January 2000 was a negative 1 percent real. The guaranteed long-term return on TIPS at the time was a positive 4 percent real. That’s a difference of 5 percentage points of return ever year for 10 years running. It’s the safe asset choice that was providing the far better long-term return.

    That’s efficient??????

    That’s insane.

    Why not call it the Insane Market Theory?

    There’s nothing efficient about it.

    It’s because the “experts” believe that the market is efficient that they told people that there was no reason to trade stocks for TIPS in January 2000. It’s because people failed to trade stocks for TIPS that they lost more than half of their retirement money in the years following.

    We have a choice. We can continue resisting the demand that human rationality places on us to acknowledge that the Efficient Market Theory and Passive Investing were MISTAKES. Or we can permit the U.S. economy to go over a cliff.

    I know which of the two options appears more appealing to me.

    Larry is on the other side. Larry is saying that it is kinda, sorta okay to let the U.S. economy go over a cliff.

    I am saying that we should admit the mistake and begin moving in a more positive direction.

    The gibberish hurts us all. It hurts us real bad. It has been doing this for a long time.

    Rob

  33. You guys would need to talk to see what is *actually* said and in what context.

    Larry makes great sense and puts forward fine observations when he is not trying to defend the Efficient Market Theory or Passive Investing.

    When he is trying to defend the Efficient Market Theory or Passive Investing, he comes off sounding like an idiot.

    I mean no personal dig with those words. I am telling it the way I sincerely see it.

    I don’t like hearing Larry make himself sound like an idiot and I have told him so. When I did this, his response was to say that I was being “patronizing” to point this out.

    He can’t get it right until he opens up his mind to the possibility of getting it right. He can’t get it right until he acknowledges that he has been getting it wrong for a long time now.

    Rob

  34. Now, was his altering his equity allocation in the late 90s an exploitation of an obvious inefficiency?

    Those are not the words I would use to describe Larry’s decision to permit himself to save his portfolio from the destruction that investing Passively at that time was inevitably going to bring to it.

    I would say that it was the triumph of common sense over pure idiocy.

    Doesn’t my way of saying it bring the point home more effectively?

    If we were not talking about investing, wouldn’t we say it the clear way?

    Why does investing have to go by different rules? Why not just say it the way it is?

    Investing heavily in an asset class paying a negative long-term return when there is an asset class available paying 4 percent real is idiocy, is it not? Is there some good reason why we don’t all feel free to point this out?

    Rob

  35. he has stunned some of the “conventionals” with his extreme-tilt portfolio and mention of valuations, and his knowledge is sought after by many, especially regarding fixed income (TIPS), where he uses valuations a lot.

    That part is all fine.

    But think how much we all would learn if he would talk straight.

    Does he think that the “conventionals” have it all wrong? If he does, why does he not say so?

    Is he ashamed to be part of a board community that has imposed a ban on honest posting on safe withdrawal rates and other valuation-related topics? If he does, why does he not say so?

    Does he hold back from saying all he knows (he once told me that he believed that the average middle-class investor needs to be “protected” from the realities of stock investing) for fear of what will be done to him if he talks straight? Does he find it offensive that this is one area in which free speech does not apply in our society. IF he does, why does he not say so?

    Either Larry really knows the realities and is holding back from telling us or he himself really does not yet understand the realities and cannot fairly be termed an “expert.” One of the two things is so, right?

    Again, it is not my purpose to hit on Larry. My purpose is to point out what we need to do to restore faith in the markets. We need to start talking straight with people. We need to stop with the baby talk and explain to people that there is now 30 years of academic research showing that Passive Investing can never work in the real world. People need to know that. People are investing their retirement money in stocks. Lots of people are doing this.

    It’s not all a big joke, Arty. This is real life. It’s not just zeros and ones on computer screens. Real live people are suffering real live pain. We all need to work together to bring an end to the baby talk and to encourage straight talk. The U.S. economy cannot function properly for so long as it is impossible for people to hear accurate information re how stock investing works. People have their retirement money invested in stocks!

    Rob

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