“You Are Adding a Layer of Complexity When You Start Worrying About Interest Rates. It Is Not Necessary. You Don’t Have to Consider Interest Rates to Lock In That 6.5 Percent Real Return. And There’s Risk in Considering Factors That You Don’t Need to Consider.”

Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:

RM – What do you think will happen to interest rates?

RB – “I do not focus on interest rates very much. I am very much a long term investor. Interest rates will go up and go down over the long term.”

Rob, interest rates establish THE COST OF MONEY. Surely anyone fashioning themselves as a Valuation informed Investor, who insists on price discipline in all things, who eschews stocks for the safety of bonds, would find the price of money to be an essential piece of information, and along with yield, to be one of the PRIMARY factors driving investment decisions. How do you defend your answer, given what I think is obviously the truth, as I just outlined?

Good question.

Shiller described his finding that valuations affect long-term returns as “revolutionary.” That means that it changes everything that we once thought we knew about how stock investing works.

Stocks provide an average long-term return of 6.5 percent real. That’s outstanding. It’s possible for some super-smart investors to beat that. But there is no need for the average person (the person to whom my words are directed) to do much better than that. A return of 6.5 percent real is good enough to finance a decent retirement for the vast majority of people. So the primary goal is to lock in that 6.5 percent real return as your personal long-term return or at least get close to it. That’s the name of the game.

You can’t do that without taking valuations into consideration. The most likely 10-year annualized return on stocks in 2000 was a negative 1 percent. That’s 7.5 percentage points off the mark for a significant stretch of time (most of us build our retirement portfolio from about age 25 to age 65 — so 10 years is 25 percent of the time we have to build our retirement portfolio). That doesn’t cut it. So you needed to move away from stocks in 2000. TIPS were paying 4 percent real. That’s good enough, especially for an asset class that is super-safe. You can make up for the difference between the 4 percent TIPS return and the 6.5 percent goal by investing in stocks following the next crash, when the likely 10-year return will be about 15 percent real.

You are adding a layer of complexity when you start worrying about interest rates. It’s not crazy to take interest rates into consideration. I won’t object if you do so. But it is not necessary. You don’t have to consider interest rates to lock in that 6.5 percent real return. And there’s risk in considering factors that you don’t need to consider.

Bogle argues the merits of keeping your investing strategy simple. This is one where I think he is 100 percent right. This is one of many points that Bogle has made that cause me to call him a “genius,” second only to Shiller in my assessment. You might incorporate the interest-rate factor into your strategy in an effective way. But the more complicated you make things, the more likely you are to out-smart yourself. How much do you really add by mixing in that factor? How much added risk are you taking on by making your plan more complicated?

I consider valuations because the valuations factor is huge. It’s 80 percent of the stock investing story. Ignore valuations and you are ignoring pretty much everything. You are shooting in the dark.

But interest rates are not a huge deal. Please look at the historical data going back to 1870. Investors who paid zero attention to interest rates did just fine. You can’t say that about valuations. Investors who ignored valuations hurt themselves in a big way. They took on far more risk than they needed to and they reduced their long-term return dramatically. For what purpose?

There are super-smart people who can earn a slightly higher return by taking factors like interest rates into consideration. They should go for it. But it is not for the average person, in my assessment. It complicates things and the complication is an unnecessary one and with added complexity comes added risk. I think it makes more sense just to lock in that 6.5 percent real and be satisfied with a plenty-good-enough return. That’s the strategy consistent with Bogle’s thinking and he is the king when it comes to investing strategies for the average person (with the exception of the mistake he made re valuations because all the research was not yet in when he took his initial stab at creating a research-based strategy).

I hope that helps a bit, Anonymous.

I could be wrong! It’s been known to happen! If it were happening again, I would probably be the last to know! I suffer from biases, like all the other humans!

Rob