Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
Of course you always give the caveat that people must reduce their account balance by 65% in order for your math to work, but then again, you said math wasn’t your thing.
Math isn’t my thing, Anonymous. The math supports what I say 100 percent. The math has been supporting what I say for 147 years now. So I suppose that you could say that math is my friend re this matter. But math isn’t really what gets of off, no. I care about the people. I am happy to use math to help people. But it’s the people that are my focus, not the math.
I think with the 65 percent number you might be thinking of the likely size of the next price crash. We always go below fair value before a secular bear market comes to an end. To know the true value of your portfolio, you would need to divide by two. Today’s P/E10 value is about two times the fair-value P/E10 value.
Why do you object to dividing by two? Does it not make perfect sense to divide by two at a time when stocks are priced at two times their fair value? Would you not like to know the true value of your portfolio? Do you not think that knowing that number would be a huge help in engaging in effective financial planning?
I think it makes all the sense in the world to divide by two. I think everyone should do it. I see it like brushing your teeth, huge upside and nearly no downside (the tiny bit of effort put into the task is the tiny downside). I can’t say that I have ever once in the 15 years heard any reasonable argument for NOT dividing by two.
The only one that I have been able to come up with myself is that, if you think the market is efficient, there would be no need to divide by two. I think that’s why it was not common practice pre-1981 to divide by two. But Shiller showed in 1981 that the market is NOT efficient, that valuations affect long-term returns. So that should have been the end of that. But for 36 years now we have been living in a twilight zone where few of us divide by two and yet everyone who follows the peer-reviewed research knows on some level of consciousness that we all need to do so. But they don’t say anything because it would hurt the feelings of those who don’t divide by two to realize that they have been making a terrible mistake all these years.
How is that ever going to change if a few of us don’t work up the courage to just say out loud what we realize the last 36 years of peer-reviewed research teaches us all about how stock investing works in the real world? If I keep my mouth shut, I am just one more person making the problem worse. It gets worse the longer the cover-up goes on because as more time passes it becomes more embarrassing to admit the mistake. So I try hard not to keep my mouth shut.
I try to be as gentle and loving as I can be in what I say because I don’t like to hurt people’s feelings any more than any of the rest us do. But I do make an effort to say what I believe. I believe that I end up hurting people’s feelings MORE by not speaking up. People are going to find out the realities the hard way when the next price crash arrives. Is it really a kindness to let them be surprised by seeing most of their life savings washed away with the tide? Or is the kinder thing to talk about the last 36 years of peer-reviewed research and what it means? I see this as a case where the truly kind thing is telling people the thing they very much do not want to hear.
Those are my sincere thoughts, in any event.
I naturally wish you all good things.
Rob
Anonymous says
“Math isn’t my thing, Anonymous. The math supports what I say 100 percent.”
Those 2 sentences are in conflict with each other. You admitted you lack credibility.
Rob says
I don’t see any conflict. It’s true that math isn’t my thing. And it’s true that the math supports what I say 100 percent.
Your point seems to be that you cannot place confidence in what I say re the math because I am not personally good at math. But Shiller is good at math. And Wade Pfau is good at math. And Rob Arnott is good at math. And John Walter Russell is good at math. So the point remains.
My personal belief is that people should look at things other than the math. There are LOTS of things that support VII and math is just one of them. I am personally more impressed by some of the other stuff because math is just not my thing. But it gives me a good feeling to know that the math supports VII too. I’d much rather have the math on my side than not have the math on my side.
The puzzle is how there could be anyone who does not support VII given what the math says. That’s where cognitive dissonance enters the picture. And that’s where I get super interested. The cognitive dissonance thing is fascinating to me. What should investment advisors do when one strategy is far superior in terms of risk and return but the other strategy is better from a marketing perspective because it taps into the Get Rich Quick urge within us all while the other strategy is rooted in logic and math and other stuff that does not turn people on so much?
The story here is a story of marketing vs. research. It’s a story where the marketing edge held by one of the strategies is so strong that people cannot even appreciate what the research says. People are not persuaded by the research not because there is anything non-persuasive about the research but because people will not let the research findings into their minds because they find them too darn painful to accept.
That’s not math, that’s psychology. The psychology effect here cancels out the math effect, even among people who in other circumstances place great value on what the math says (Buy-and-Holders in ordinary circumstances LOVE math). So getting the math right is not enough. To offer helpful investing advice, you’ve got to get the psychology right. And that’s not something that most people in this field worry about too much. People think of investing as a math field, not as a psychology field.
One of the many far-reaching implications of Shiller’s “revolutionary” (his word) findings of 1981 is that the investing advice field is a field in which understanding psychology is more important than understanding math. So that’s the direction in which we need to move. In the future, we will never talk about the math without taking the effort to put it into a psychological context because there is a risk that people will not understand the math if we haven’t first put it in the proper psychological context.
Is Shiller a psychology guy or a math guy? I would say that he’s a psychology guy. His primary contribution is on the psychology side. But he likes to present himself as a math guy. He does that all the time. He uses the same sorts of tables as the Buy-and-Holders use. He likes to take surveys. That way he can talk about people’s beliefs and feelings and have numbers next to them in the places where he presents them. He uses charts and graphics, which are not that common in the psychology field, to make his points. He is almost always making a psychology-related point. But he makes an effort to make the point through the use of numbers rather than just narrative. Because that’s what people in this field do. It makes him fit in better for him to do that.
I don’t fault him for it. I think that it’s great that he does that. He takes psychological concepts that possess great power and importance and expresses them with numbers so that he is using the language that people in this field understand and appreciate and accept. So good for him.
There are limits with how far you can go with that, though. My contribution is often to take the psychological-concepts-presented-in-math-form that Shiller and others are putting forward and to translate them into the sort of narrative that you would expect to hear if they were being presented in a field other than the investing advice field.
The best example of this was when Bill Bernstein made the case that the Buy-and-Hold retirement studies get the numbers wildly wrong because they don’t include valuation adjustments. Those are my words, not his. What Bernstein did (in his book The Four Pillars of Investing) was to say that, to adjust for the valuation level that applied near the top of the bubble, you need to subtract two points from the withdrawal rate identified by the Buy-and-Holders as safe — 4 percent. Bernstein didn’t perform the math exercise. He didn’t say “subtract 2 point and you get a safe withdrawal rate of 2 instead of 4.” He just gave people the math-based information they needed to figure out the correct number for themselves. He understood that he would upset people if he said plainly that “the safe withdrawal rate is today 2” because that enters the psychology zone. Tell people that and you are going to cause them to experience intense anxiety.
I go the extra step. I say “the safe withdrawal rate is today 2 percent” That statement is the product of a math exercise but it has psychological import as well. That statement scares people who planned their retirements based on a belief that the safe withdrawal rate is 4. So it is not just math anymore when you say it that way. And I of course take it even a step further. I don’t just say “the safe withdrawal rate is today 2 percent.” I say “that means that we are likely going to see millions of failed retirements in days to come because we have been telling people for years now that the safe withdrawal rate is 4 percent and they believed us.” That’s an INTENSE psychology statement. That statement leaves the math behind and travels to places that Bill Bernstein does not dare go.
I am famous for making statements like that and then refusing to take them back or to shut up about them or whatever. I am a pain inflictor. Not because I don’t like my Buy-and-Hold friends. Because I think that what the math is telling us is important and has psychological implications that need to be explored.
I added the second part to this comment Thursday morning after re-reading what I had written Wednesday night. I read the initial response and I realized that I wanted to say a bit more about how I take math concepts advanced by people like Shiller and Bernstein and push them into the psychological realm.
The psychological realm is where I think the real action is. The math is important. I don’t at all mean to denigrate the good people who focus on the math. But I believe strongly that the psychological stuff is what drives the investor decision-making process in the investing realm and so we must be willing to explore psychological stuff in great depth to do truly effective work in this realm. So I make it a practice to push the math stuff to the next stage, to the psychological stage.
That’s why you Goons hate me. You don’t want to know what the math says. You want to live in a world of illusion. You tolerate the Bernsteins of the world and to a point even the Shillers of the world. They are willing to present their math-based stuff and then shut their mouths about the obvious psychological implications of what the math tells us. That’s bearable to you. You don’t like it. You would be happy if they would knock it off and be Bogle-pure. But you get it that sometimes a guy feels a need just to report the math accurately no matter what crazy thing it says. So you tolerate Bernstein (and Shiller, to a lesser extent).
But I cross the line. I say “so we need to correct those bogus retirement studies before they ruin more middle-class lives!” That’s a bannable offence. That is the sort of thing that simply must not be said. That comes pretty darn close to accusing the Buy-and-Holders of financial fraud. That sort of statement requires ACTION. You don’t want to act. You want to live in the comfortable, complacent world of 1980, in the days before Shiller did that darn math exercise that caused him to be awarded a Nobel prize in Economics. I blotted that happy world out with my math-translated-into-psychology statement. So I must be blotted out!
The reason why I did only saving work and never investing work in my early years is that I saw that investing was a numbers-oriented field. Numbers are not my thing, psychology is my thing. So I stuck to saving, where it is accepted that psychology (motivational stuff) plays a big role and left investing to the “experts.” Then Greaney’s Goon Squad launched their smear campaign against Wanderer, who was a guy who wrote effectively about saving from a emotion-based perspective. That’s when the numbers-based stuff at the old Retire Early board bled into the psychology-based stuff. Greaney violated the unspoken agreement where people from both sides stayed on their own turf and left people who wanted to play on the other side alone. He wasn’t going to permit the psychology-oriented side of the board community to continue to exist because something that Wanderer said about real estate threatened him too much.
I used the same psychology-oriented arguments that I had had such success with on the saving side in the discussions of investing that followed. But they didn’t bring about the same result! People are not used to hearing psychology arguments in investing discussions. Where are the numbers, man? Investing has long been a numbers-based discipline. People expect to see numbers, not narratives. And certainly not song lyrics!
Shiller is a transitional figure. He makes psychology-based points using numbers. He makes an effort to speak the language of the Buy-and-Holders. I make an effort too. But I am less willing to compromise my psychology-based points to make them palatable to people expecting to see investing-oriented points presented through the tools that are most commonly employed in a numbers-focused field.
I think we give up too much when we limit ourselves in that way. I think that there are many important things that Shiller either understands or is close to understanding about how stock investing works that he has never told us because he is held back by his fear of leaving the numbers behind at times and framing his psychology-based points in the way they would be framed in any field without such a long history of sticking to the numbers.
I started out that way. I started out being as fearful as Shiller is of crossing the line, probably more so. Before May 13, 2002, I didn’t speak up AT ALL. But over time, I learned that holding back just doesn’t work. If you are going to say that the Buy-and-Hold retirement studies are in error and need to be corrected (I needed to say this much because of the circumstances that applied in a board community in which John Greaney was present), then you were persona non grata no matter how soft you played it and you might as well just let it rip. I still make a big effort to be polite because I have a general belief that that’s the way to go. But I state my investing points more boldly than Shiller dares to present his or than anyone else in this field dares to present his.
Math is great. I APPROVE of math. But math can only take you so far. At some point you have to DO SOMETHING with the math. If the Buy-and-Hold retirement studies are in error, then you need to get off your bottom and produce ACCURATE retirement studies, retirement studies that include valuation adjustments because the aim is to get the numbers right. Those sorts of studies are going to upset Buy-and-Holders not matter how gentle you are in your presentation. Your words that “you guys got the numbers wrong!” are fighting words to the Buy-and-Holders no matter how micey nice you are in the words that surround those words.
So you might as well just let it rip. If the Buy-and-Holders are going to threaten to kill your wife and children in any event, you might as well just go ahead and tell the full story to the best of your ability for that 10 percent that is losing confidence in Buy-and-Hold and that is open to hearing about a new truly research-based strategy.
Whew!
You got me going a bit with that one, my long-time Buy-and-Hold friend. Now I am pumped for the new day!
Rob
Anonymous says
“It’s true that math isn’t my thing. And it’s true that the math supports what I say 100 percent.”
Your understanding of the math begins and ends with “yup, that’s a dang high PE10.” Since that’s the only thing you understand, you stubbornly insist that that’s the only thing that matters.
But if it mattered that much, why isn’t the second highest PE10 in history enough to get Shiller to even issue a warning? (Today. Not in 1996.)
The obvious answer (to everyone but you) is that it doesn’t matter that much. Shiller has learned that the market isn’t that simple, so he moved on. Moving on is even less your thing than math.
Rob says
It’s not that the P/E10 is high that concerns me so much. I 100 percent accept that you can have have a very high P/E10 number and not see an immediate crash, that you can even see 30 percent or 40 percent or 50 percent annual gains starting from a high P/E10 number. That’s not my focus.
My focus is what Shiller’s 1981 finding tells us about how the market sets prices. If the market is efficient, as people believed it to be in the days when Buy-and-Hold was being created, then prices are set through a rational process. It is unforeseen economic developments that cause prices to rise or fall. If that is so, then Buy-and-Hold is the ideal strategy. If that were so, I wouldn’t care what the P/E10 was, I would just follow a Buy-and-Hold strategy.
What Shiller did that was so important was to test this core Buy-and-Hold belief, Is it really unforeseen economic developments causing prices to rise and fall? That was never proven, it was an assumption. The thing that you do in science is that you test things. Is there a way to test that assumption?
There is. Shiller was the first person to test the assumption. If the assumption is correct, prices should fall out in the pattern of a random walk. There’s no pattern that should apply with unforeseen economic developments, sometimes they are going to take prices up and sometimes they are going to take prices down. This is why Fama was awarded a Nobel prize. He seemed for a time to have proven that the assumption is correct. He showed in his research that stock prices do indeed play out in the form of a random walk in the short term (up to 10 years).
Fama didn’t even think to test whether prices play out in the form of a random walk in the long term. Long-term timing was not a practical option in the day when Fama did his research. Long-term timing only works with index funds and index funds did not exist in the 1960s, when Fama did his most important work. Bogle formed Vanguard in the mid-1970s. Then Shiller became the first researcher to test long-term timing in 1981.
He found that it always worked. He found that market prices do NOT play out in the form of a random walk. He found that the assumption on which our understanding of how investing works was in error.
If it is not unforeseen economic developments that cause stock price changes, what is it? It is investor emotion. That is the theory that Shiller puts forward and it is the only one that I have heard that makes sense and that is consistent with the peer-reviewed research of the past 36 years. That changes everything. That is a “revolutionary” finding. That finding merits a Nobel prize.
Not because we know now that a P/E10 of 30 means that a crash is coming next week or next month or next year. We don’t know that. Shiller didn’t show that. That’s not the point.
The importance of Shiller’s research is that it shows us that stock price changes are caused by shifts in investor emotion, not by unforeseen economic developments. We cannot say that there is going to be a crash soon just because the P/E10 is 30 because emotional investors might just ignore the high P/E10 level and push prices up to 35 or 40 or 45. Shiller didn’t give us information that helps us to predict short-term price changes.
What he did was to give up information that tells us that some stock price changes are rooted in real economic stuff and some are rooted in ephemeral emotions. Prices are caused by shifts in investor emotion. They follow a clearly defined pattern that has remained in place since the first day that stocks were offered for sale. The primary driver is the Get Rich Quick emotion. So the P/E10 level gradually increases over time. First it is 8, then a few years later it is 12, then a few years later it is 17, then a few years later it is 21 and then a few years later it is 26 and so on. The secondary driver is the Common Sense emotion. The Common Sense emotion causes people to feel fear over the long-term value of their emotion-generated returns. The Common Sense emotion causes prices to crash back to 8 so that the gradual-upward-movement part of the long-term pattern can reassert itself. The market always brings overpriced stocks back to fair-value levels or lower. There has never once been an exception.
Today’s P/E10 level is insane. But we cannot say that we are going to see a crash next week or next month or next year. Next year’s P/E10 level could be even more insane that this year’s P/E10 level. We just don’t know.
What we DO know is that stocks are a lot more risky today than they were the last time they were selling at reasonable prices. The more emotion there is present in the price at which stocks are selling, the more pressure there is for sharp downward movements in prices. The more risky stocks are, the less your stock allocation should be if you are seeking to maintain a steady risk profile. Stocks are insanely risky today. Prices might go higher. Then they would be even MORE insanely risky.
The question is — Do you want to gamble that prices will continue moving upward from these insanely risky levels? I do not want to gamble. I don’t care if prices double from where they are today before crashing back to a P/E10 level of 8. I am a long-term investor who does not believe that it is possible to engage in short-term timing successfully. So I don’t believe that I will know when to get out to avoid the crash that is inevitably going to come. So the only way to diminish the effect of the crash is to lower my stock allocation not when I think that the crash is about to arrive but when risk gets so high that stocks no longer represent a strong long-term value proposition.
It doesn’t make much difference to a long-term investor whether stocks crash next week or double in price from here and then crash a few years from now. The investor loses all those phony gains in any event. So why spend so much mental energy trying to figure out when the crash is coming? I don’t think it can be done. I just try to keep my risk profile roughly stable. If I do that, I am covered in all possible circumstances.
I think you are focused on the wrong thing, Anonymous. You don’t want to “miss out” on temporary gains. I focus on whether the gains are permanent or temporary. I don’t fret about temporary gains one way or the other. I just don’t care. I naturally don’t want to miss out on permanent gains. That’s where I direct my attention. I focus on distinguishing temporary from permanent gains.
Gains that are supported by the economic realities are permanent. There has never in the history of the market been a time when those went away. Yes, the market price can do down below fair value just as it can rise above fair value. But it always comes back when it does. That’s the beauty of it. If you focus on the real value of your portfolio, you always know where you stand and you always know what direction prices are moving in the long term. It makes financial planning about 50 times easier than it is when you are pretending that it is unforeseen economic developments driving prices rather than the crazy emotions of human investors.
What I learned from Shiller is that high prices are caused by investor emotion. That tells me to go easy on stocks when investor emotion gets too out of hand.
Shiller hasn’t “moved on.” If the Buy-and-Holders would drop the criminally abusive behavior, he would be 100 percent happy to talk these things over with you and to tell you everything he believes in a calm and clear and detailed way. There are some things he doesn’t know. He would learn those things over time by talking things over with you and with lots and lots of others. He is not able to do that today because you do nuts when anyone even suggests that the Buy-and-Holders might have made a mistake in earlier days and then failed to correct it for the 36 years since it came to light.
When the behavior of the Buy-and-Holders changes, our knowledge of how stock investing works will advance by leaps and bounds. We have 36 years of peer-reviewed research that we have not permitted ourselves to explore. That will change following the next price crash. We will explore the many far-reaching implications of Shiller’s research in days to come. I of course wish that we had begun those explorations back in 1981. We would have prevented a mountain of human misery by playing it that way. But the full reality s that the good news here is 50 times more good than the bad news here is bad. So we will just have to take the good with the bad and “move on,” to quote a phrase.
My best wishes.
Rob
Anonymous says
As always, a wall of text to avoid the key question.
If PE10 matters, then this is the second worst time in history to hold stocks. Worse than before the Great Depression. So why isn’t Shiller warning us?
Your stupid answer (Goons) is rejected. There are two possibilities. Either he doesn’t believe or know whether a crash is coming, in which case PE10 is worthless. Or he does know and isn’t telling us, in which case he’s a terrible person.
But he is certainly not saying what you’ve been saying for years, that millions of middle class investors are about to be wiped out.
Rob says
His research says that. His entire life’s work says that.
Shiller pulls his punches. I certainly don’t deny that. But he says the same things that I say to all who are open to hearing the message. The title of his book is “Irrational Exuberance.” If he believed what Bogle believes, the title would be “100 Percent Rational, Perfect Pricing.” He used the other title to make a point. And he backs up that point in every page of the book.
I would feel that I was a “terrible person” if I said things in the way that Shiller says them. That much is so. I feel a need to state things more clearly.
But there’s an argument the other way. Shiller probably believes that he can do more good saying things in the way that he says them. At least he is not banned from the internet. At least he gets invited on shows and things like that. I might never have heard about Shiller if he had said things precisely how he believes them and had been banned from the internet before I even came on the scene. I have learned a lot from Shiller and I am grateful for what I have learned. And I of course acknowledge that he is not crazy to believe that some Buy-and-Holders will go nuts if he states things clearly. So I am not going to judge him.
But it troubles me that we are 36 years down the road and we have not made a whole big bunch of progress. Is Shiller’s way of saying things got the job done, we would not be living through an economic crisis today and we would not have a P/E10 of 30 today. So I think it is fair to say that those of us who believe that the last 36 years of peer-reviewed research is legitimate research are going to need to begin speaking out a bit more frankly.
People need to plan their retirements effectively. They will not be able to do so until the internet is opened to honest posting on safe withdrawal rates and scores of other critically important investment-related topics. One definition of insanity is to continue doing the same thing over and over again and to expect different results.
That’s my sincere take, in any event.
I wish you all the best that this life has to offer a person, my long-time Buy-and-Hold friend.
Rob