A Rich Life

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

Economics Professor Valeriy Zakamulin: “If Stocks Are No Longer Risky, They Should Provide the Same Return As Money Markets.” Rob Bennett: “You Are Touching on the White-Hot Core of the Dispute.”

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I have been contacting numerous people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by The Buy-and-Hold Mafia.

Yesterday’s blog entry reported on the correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail sent to me by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:

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Rob:

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My comment on the following: “My view is that we are on the verge of a huge breakthrough. We now know how to assess risk effectively (look at the P/E10 value!). Once we know how to assess risk effectively, we know how to eliminate risk. There is no reason why stocks need to be a risky asset class. We made them a risky asset class for many years because of our ignorance of the realities. “

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You see, the basic postulate in finance, and it is completely rational, is that “no reward without risk”. Since stocks are risky, then they need to provide a higher (expected) rate of return than money markets. This is what we actually see looking back at the history, namely, stocks provided higher returns than bonds and money markets. Without any risk, if stocks are no longer risky, they should provide the same return as money markets. What is the point to invest in stocks in this case?

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Valeri

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I replied:

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Valeri:

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You are touching on the white-hot core of the dispute with this one.
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I don’t agree that the thing that stock investors are being paid for is a willingness to take on risk. I believe that this idea became popular in the days before index funds. Then there really was risk — the investor was sharing in the fortunes or lack thereof of the company in which he bought shares of ownership. Indexing changes all that. When you buy an index fund, you are buying a share in the productivity of the U.S. economy. That economy has been sufficiently productive to produce an annual return of 6.5 percent real for 140 years now. So in all likelihood that’s roughly what you are going to get (provided you don’t overpay or underpay for your shares). The number could change a small bit in either direction. But with an advanced economy dramatic changes in either direction are unlikely. The investor is being paid for the use of his money, which is put to productive uses. His money is essentially being rented and his return is the rental fee. You give up control over the money for a period of time and in return you get an annual return of 6.5 percent real, plus or minus whatever adjustment is needed to reflect the fact that the shares were overpriced or underpriced at the time you made the purchase.
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It’s true that, when investors come to realize that index funds purchased in a valuation-informed way are not significantly more risky than Certificates of Deposit (CDs), the disparity in return on stocks and on CDs will need to tighten. But this doesn’t necessarily mean that the return on stocks will drop; the tightening can be achieved by a rise in the return on CDs. The return on stocks is set by the productivity of the U.S. economy. The return on CDs is set by the need of the banks offering them for sale to offer a return high enough to attract the investors needed to purchase their offerings. Here it is the PERCEIVED risk (NOT the actual risk) of stocks that matters. Stocks have never in history been as risky as they were in 2000 (when prices are at three times fair value, prices are certain to fall hard in coming years). So, according to the conventional theory, stocks should have been offering amazing returns at the time to compensate for the insane level of risk being taken on by investors. The reality is that the most likely annualized return 10-year return on U.S. stocks at the time (as determined by a regression analysis of the historical return data) was a negative 1 percent real (See The Stock-Return Predictor). TIPS and IBonds and CDs were at the time offering a return of 4 percent real. That’s a differential of 5 points real of return each year for 10 years running, a total penalty for the stock investor of 50 percent of his starting-point portfolio value. Where’s the compensation for buying stocks at the riskiest time to own them in U.S. history?
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The reason why we had an equity risk PENALTY at the time is that the PERCEIVED risk of stocks was low. Buy-and-Hold was being pushed relentlessly at the time and millions of investors had become convinced that there was no need to consider price when setting their stock allocations. In fact, many investors had come to believe that the only possible risk in stock investing was the risk associated with a lowering of one’s stock allocation! Investors act on perceived risk, not real risk. In 1982, when risk was nil (prices cannot drop lower when they are already at one-half of fair value and the investor obtains a return of 6.5 percent real when prices remain at fair-value levels), the most likely annualized 10-year return was 15 percent real. There was no need to compensate stock investors for taking on actual risk at this time. But there was a great need to compensate them for taking on perceived risk. Perceived risk is always greatest when real risk is lowest (because it is low prices that cause investors to fear stocks).
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If we educate investors to the realities and stock valuations stabilize, the risks of stock ownership will drop to levels not much higher than the risks of owning CDs. Banks will no longer be able to sell CDs providing returns far below the returns available from stocks in an environment in which stocks are no longer perceived as carrying much more in the way of risk (the appeal of CDs today is their low perceived risk). So they will have to increase the returns paid by CDs. They of course can do this since the money obtained by selling CDs can be put to equally productive uses as the money obtained by offering shares of stock. Banks indeed HAVE paid high returns on CDs at times like the late 1990s when the perceived risk of stocks was so low that there was no other way to market the CDs. The reason why CD rates are so low today is that the perceived risk of stocks in the minds of many investors is high and these investors are willing to accept low returns to escape that perceived risk.
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It is true that on an overall basis the historical record shows a higher return for stocks and more risk for stocks. This is why many have come to believe that stocks pay higher returns BECAUSE of the higher risk attached to them. But index funds have only been available since 1976. We are still in the early stages of thinking through how this entirely new asset class operates. And the historical record does NOT support the conventional view of risk when you compare risk and return offered at particular times. At particular times, there is a negative correlation. High prices mean high risk and low returns. Low prices mean low risk and high returns.
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Again, these are merely the sincere views of a non-expert who has spent a lot of time trying to understand conflicts and weaknesses in the conventional understanding of stock investing. I believe what I am saying here. But I am just one guy who never studied investing in school and who never managed a fund and I of course could be partly or entirely wrong.
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I thank you again for your willingness to engage in a back-and-forth discussion that I find highly stimulating.
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Rob

“Investors Should ALWAYS Aim to Keep Their Risk Profile Right. Whether the Economic Outlook Is Bright Doesn’t Matter — That Is Cooked Into the Price, So It Doesn’t Need a Separate Analysis.”

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I have been writing many people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of my reply to the e-mail detailed in the earlier blog entry:
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Valeriy:

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Re the first point — You’ll get a different result if you factor in whether the fair-value P/E10 number appears on the way up or the way down. When we see a P/E10 of 15 on the way up, the P/E10 that applies 10 years later is always a good bit higher. When we see a P/E10 of 15 on the way down, the P/E10 10 years later is always lower. It’s not the number alone that matters. You need to take into consideration what type of investor emotion it is that produced the number. It’s no failing of P/E10 that it doesn’t produce good predictions from a fair-value start for those who do not take investor emotions into consideration. That’s a failing on the part of those performing the analysis. P/E10 always works for those willing to consider both numbers and emotions, both of which are critical aspects of the stock investing story.
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Re your second point — I believe that investors should ALWAYS aim to keep their risk profile right. That’s the key to success. Whether the economic outlook is bright doesn’t matter — that is cooked into the price anyway so it doesn’t need a separate analysis. This all comes down to risk management, in my assessment. The P/E10 value is telling us how risky stocks are. If all investors aimed to keep their risk profiles constant (they would if only we would tell them how to do it), stock prices would always self-correct and all would be well. Fama was right that the market WANTS to be efficient. What makes it inefficient is the Social Taboo that says that we must not tell people about the dangers of going with high stock allocations at times of insanely high P/E10 values. We want to be rational. But we cannot pull it off without access to good information and those of us who understand the realities dare not provide good information in light of the intense social pressures imposed on us not to speak too clearly about these matters.
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My view is that we are on the verge of a huge breakthrough. We now know how to assess risk effectively (look at the P/E10 value!). Once we know how to assess risk effectively, we know how to eliminate risk. There is no reason why stocks need to be a risky asset class. We made them a risky asset class for many years because of our ignorance of the realities. But we have overcome our ignorance over the past 50 years. Now we just need to give ourselves permission to talk through and think through all that we have learned and to share the insights we have developed with all interested parties without apology or hesitation.
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I don’t think that a wise use of P/E10 ever calls for getting entirely out of stocks. It never predicts short-term results and short-term results matter. P/E10 is a risk-management tool. Should investors have lowered their stock allocations in 1996? Absolutely. Should they have gone to zero stock allocations? No. The aim should have been to keep their risk profiles roughly stable. So an investor who properly went with an 80 percent stock allocation in 1982 might properly have gone with a 20 percent stock allocation from 1996 forward. But not zero.
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Please note that those who dropped to 20 percent stocks in 1996 are ahead of the game today. And they will be even more ahead of the game after the next crash. And the differential will grow and grow over the decades of compounding to come. Wade’s research shows this:
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Please understand that I am only stating my sincere views. I obviously do not know it all. I have been wrong about important things in the past and it could be that it is happening again. I am telling you what I believe because you are asking good questions and I love to be able to share this stuff, which I view as being very important. But I am not trying to say that I know it al. We need to have everyone sharing his or her sincere views if we are to hope that as a society we can advance in our understanding of this stuff. I am certainly grateful for the challenges to my thinking that you have advanced in our e-mail communications. They force me to think and to reconsider points where I may have made mistakes. But you need to know that I am biased. I cannot help it.
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Rob

Economics Professor Valeriy Zakamulin: “If the Bubble Occurs, It Is Rational to Participate In It”

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I’ve been e-mailing lots of people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of an e-mail sent by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:

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Rob:

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First of all I would like to comment the following:

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The right way to think about this (in my view!) is that P/E10 tells you the extent of risk in the market. It never identifies the precise return that will apply in 10 years. It always identifies the range of possible returns (the range is 6 points in either direction — when prices are at fair-value levels, the range is from an annualized 10-year return of 0 on the down side to an annualized return of 12 percent real on the up side) and assigns rough probabilities to an actual outcome falling at any point on the range of possibilities (the most likely 10-year outcome starting from a time of fair-value prices is an annualized return of 6 percent real).
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What I am telling in this context is that if the PE10 ratio is way too high or way too low, then the precision of your forecast (the range of possible outcomes as measured for example by plus minus one standard deviation) is rather good. If the PE10 ratio is close to its long-run mean, then the range of possible outcomes is too wide to be useful for forecasting.

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My comment on the following: If we tell people how stock investing works, we will never see such extreme P/E10 values again. Once we get the word out, stock prices become self-regulating. If people understand that they MUST change their stock allocations in response to big price swings, each swing upward will bring on sales and those sales will pull prices back to fair-value levels again. There can never be another bull market or another bear market once we permit open discussion of Shiller’s findings. 

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First of all, it seems to me that we agree that people are not fully rational. Second, it will not be correct to say that it is rational that the PE10 ratio should always be about 15. In a rational expectation model the value of PE (hence PE10) depends on some, sometimes unobservable, parameters. For example, the investor’s risk aversion, the derivative of which is the market price of risk. Third, I do believe that the Shiller’s work did its job, now many people understand that it is not rational to have a PE10 value of 44. Forth, despite this, even in a rational expectation framework if the bubble occurs, it is rational to participate in it. As an example, image that you are in 1993 and you see a bubble in the stock market, yet the economic outlook is very bright, the investors’ optimism is high, and it looks like the bull market will continue for a long time. Will you get out of the stocks and miss the bull market till 2001? I doubt.

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Valeriy

“We Were at 3x in 2000. We Will Be at 0.5x When This Is Over. That’s a Loss for Every Stock Investor of Five-Sixths of His Accumulated Wealth of a Lifetime.”

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I have been contacting numerous people to let them know about my article on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of my response to the e-mail detailed in the earlier blog entry:

Valeriy:

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I get what you are saying here and I agree with most (but not quite all) of it.
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I 100 percent agree that excessive P/E10 values over-correct. That is a hugely important point and one that even many who believe in P/E10 do not get.
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The important question (in my mind) is — Why?
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I believe that P/E10 is reporting to us the state of investor emotions. In 2000, we were insanely in love with stocks. So the nominal price at the time was at three times the true and lasting value (let’s call it 3x). The REASON why prices always over-correct is that the drop from 3x to x is emotionally devastating. The drop from 3x to x causes a loss of $12 trillion of buying power in our economy. That loss causes tens of thousands of businesses to fold and puts millions of employees out of work. The economic destruction causes us all to lose hope for the future. Our despair causes us to lose hope that stock prices will ever recover. So the P/E10 value falls not to fair-value (15) but to one-half of fair value (7 or 8). There has never been an exception to this rule. Every secular bull market has produced a secular bear market that put us at 7 or 8.
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Please consider what this means in the current context. We were at 3x in 2000. We will be at 0.5x when this is over. That’s a loss for every stock investor of five-sixths of his accumulated wealth of a lifetime (assuming a 100 percent stock allocation — you need to lower the loss to reflect the percentage of a portfolio not in stocks in 2000). This is why it is so imperative that we get word out re all this. To get to a P/E10 of 7 would take another 65 percent price drop over the next few years. That would put us in the Second Great Depression.
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But this is 100 percent optional Great Depression! A P/E10 of 7 is as insane as a P/E10 of 44. If we tell people how stock investing works, we will never see such extreme P/E10 values again. Once we get the word out, stock prices become self-regulating. If people understand that they MUST change their stock allocations in response to big price swings, each swing upward will bring on sales and those sales will pull prices back to fair-value levels again. There can never be another bull market or another bear market once we permit open discussion of Shiller’s findings. We want people to invest in a rational way. But people cannot be rational without easy access to good information and the idea that is constantly pushed that timing is in some way a bad thing causes those who understand how important long-term timing is to keep their mouths shut about it. So investors do not today have access to the information they need to make intelligent choices.
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Stock prices cannot be precisely predicted at ANY P/E10 level. That is because prices are determined by emotion in the short term (up to ten years) and by economic realities in the long-term (over 10 years). The price that applies at any given time is a combination of short-term and long-term effects. Long-term prices are to a large extent predictable but not fully so because prices are always at least to some extent influenced by the investor emotion that applies at the moment and this is never predictable at all (emotion is irrational and thus cannot be predicted). Some people say that the r-sqaured for P/E10 does not show a large enough correlation. It shows the precise amount of correlation that we should expect if the Shiller model is accurate! We should not expect a perfect correlation because Shiller says that emotion affects prices in the short term and so the short-term aspect of any price should never be predictable. The market behaves exactly as we would expect it to behave in a world in which Shiller’s understanding of how the market works is the right one.
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The right way to think about this (in my view!) is that P/E10 tells you the extent of risk in the market. It never identifies the precise return that will apply in 10 years. It always identifies the range of possible returns (the range is 6 points in either direction — when prices are at fair-value levels, the range is from an annualized 10-year return of 0 on the down side to an annualized return of 12 percent real on the up side) and assigns rough probabilities to an actual outcome falling at any point on the range of possibilities (the most likely 10-year outcome starting from a time of fair-value prices is an annualized return of 6 percent real).
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People have a hard time relating to this because we are all accustomed to focusing on the short-term, what will happen in the next year or so. The Buy-and-Holders showed that that is a waste of time (I believe they are right that short-term timing never works and I believe that this was a major advance). What the Buy-and-Holders missed is that long-term outcomes are nothing at all like short-term outcomes. Long-term outcomes are HIGHLY predictable. Buy-and-Holders advise against all forms of timing because they believe that risk is stable and thus the best bet is to maintain a constant allocation. Valuation-Informed Indexers believe that risk is variable and that the key strategy imperative is to keep one’s personal risk profile constant and this REQUIRES long-term timing. If long-term timing works, staying at the same allocation at all times is an insanely risky choice. It is ALWAYS going to produce a wipeout sooner or later. And, indeed, in the historical record we see just this. Those who remain at a high stock allocation ALWAYS experience at least one wipeout at some point in their investing lifetimes (which delays their retirements by years or in some cases by decades).
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A fair-value P/E10 on the way up is a very different thing than a fair-value P/E10 on the way down. It’s not the number alone that matters. You need to take into consideration what CAUSES the fair-value P/E10 number. A fair-value P/E10 on the way up is caused by POSITIVE investor emotions — people are getting over the panic they felt during the preceding crash and slowly gaining confidence in the stock market again. A fair-value P/E10 on the way down is caused by NEGATIVE investor emotions — people are terror-struck at the prospect of losing all their money but not able yet to fully process the damage they did to their portfolios by following Buy-and-Hold strategies during a bull market.
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One of Shiller’s most important lessons is that stock investing is NOT purely a numbers exercise. We can use numbers to generate insights. But the numbers must always be considered in light of the reality that investing is done by humans, who are emotional creatures. Strictly numbers-based analyses leave out an important part of the equation. This is why much of the research in this field has gotten off track (n my view!).
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Thanks again for the stimulating back-and-forth and for caring enough to at least take a look at some of my thoughts re these matters.
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Rob

Economics Professor Valeriy Zakamulin: “If the Current P/E10 Ratio Is Near the Long-Run Mean, the Shiller Model Cannot Predict Anything.”

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I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia. 

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of his next e-mail to me:
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Hi Rob,

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I looked at your blog, you advocate the Shiller’s PE10 model. It can indeed predict returns to some extent, and this model is very popular among practitioners.

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Yet the majority of people do not understand correctly the implications of this model.

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The correct implication that everyone understands: if the current PE10 ratio is way too far from its long-run mean, then there is something extremely wrong with the valuation. In this case the model predicts that sooner or later there will be a big correction.

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The incorrect implication: the majority of people believe that the Shiller’s model implies that if the current PE10 ratio is near the long-run mean, then the market valuation is correct and one should expect the returns equal to the long-run mean returns. The problem is that people do not really understand the nature of mean reversion. The mean reversion is not just returning back to the mean. What the Shiller’s model really implies is that “an excess in one direction will lead to an excess in the opposite direction”. So if the market was highly overvalued in 2000, then the PE10 ratio should first decrease to the mean, then move further down so that the market will be undervalued. Every secular bull market starts at a PE10 value which is way below the long-run mean.

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You need to understand the following: IF THE CURRENT VALUE OF PE10 RATIO IS NEAR THE LONG-RUN MEAN, THE SHILLER’S MODEL CANNOT PREDICT ANYTHING!

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To understand, just look at the chart of PE10

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http://en.wikipedia.org/wiki/File:S_and_P_500_pe_ratio_to_mid2012.png

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For example, at about 1970 and 1990 the PE10 ratio was at the long-run mean. Did it mean that the 10-year return would be “average”? On the contrary, during 1970s the stock market return was way below average whereas during 1990s the return was way above average.

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Valeriy

Economics Professor Valeriy Zakamulin: “I Can Understand Why Robert Shiller Cannot Tell People About All His Ideas on How Stock Investing Works. He Must Act Very Professionally. He Can Only Tell Those That Are Supported by Scientific Research.”

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I’ve been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail that Valeriy sent me in response to the e-mail detailed in the earlier report:

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Dear Rob,

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I apologize for not being able to respond to all points in your mail, I just do not have so much time.

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When it comes to the paper of Arnott, co-authored by Nobel Laureate H. Markowitz, I am familiar with the paper. First, if a Nobel Laureate co-authors a paper, this does not automatically means that this paper is an excellent paper (if you are interested in the flaws of other Nobel Laureates, read about the collapse of the Long Term Capital Management http://en.wikipedia.org/wiki/Long-Term_Capital_Management). This paper does have some weaknesses. For example, the size effect is mainly due to the January effect, the value effect is also partly due to the January effect. This paper, which supposedly explains both the size and value effects, cannot account for the January effect.

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I can understand why Robert Shiller cannot tell people about all his ideas on how stock investing works. Being a recognized Yale Professor, he must act very professionally, he can only tell those that are supported by scientific research.

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It seems to me that you do not really understand how the market timing strategy works and a possible total collapse of the stock market. From the long-term perspective, the period of 1990s was a period of a great stock market bubble according to the PE10 model. But was it rational to withdraw money from stocks in 1990 and put them into bonds? Not at all, if you used Shiller’s model you would miss the great return over 1990s. Market timing strategy implied selling the stocks in about 2001 and place money in bonds. But what if all investor pursued this strategy? I am sure that all the stock prices would dropped to zero. You disagree with the assumption that investors are rational, but at the same time you actually believe that investors are rational and the mass sale of stocks ends when the PE10 ratio approaches its long-term average. This will never happen if the investors are irrational. As a proof of my point, read about the stock market crash of 1987 (see for examplehttp://hnn.us/articles/895.html). One of the main causes was the popularity of the portfolio insurance strategy which requires selling stocks when prices drops. When everyone implements this quite sensible strategy, then the stock market crashes.

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I am not familiar with the papers by W. Pfau, if they were critisized, maybe the critique was well grounded?

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I believe that if people knew about PE10 model in 1970, then the period afterwards would be a period of only good economic times. Here you are wrong. The stock market is only a barometer of the state of economy. I believe that for a capitalism economy it is natural to have periodic boom-bust cycles.

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Valeriy

“The Problem We Have Is a Circular One. The Experts Say That Buy-and-Hold Can Work Because This Is What People Want to Hear. And the People Want to Hear It Because in an Earlier Time They Were Persuaded by the Experts that Buy-and-Hold Could Work and Now Their Retirements Are Riding On It.”

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I’ve been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my e-mail correspondence with Economics Professor Valeriy Zakamulin. Set forth below is my response to the e-mail detailed in yesterday’s report:
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Valeriy:

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You are making great points and asking important questions. Thanks for being willing to get down to the nitty gritty of all this.
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What I believe in might be termed a “Conspiracy of Ignorance.” I believe that the humans gradually acquire knowledge over the years. We start out not knowing and then over time we come to know. I don’t think that people are meeting in a dark room and crafting plans to trick everybody. I believe that people misunderstand how stock investing works and pass along their misunderstandings when they share what they think they know with others.
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I believe that the Efficient Market Hypothesis was an advance over what we had before. It was a tool that helped us advance. But I also believe that belief in it has become dogmatic and the dogmas are holding us back.
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I understand the point you make about the default belief (the “presumption of innocence”). Ideally, there would be no default belief. We would just tell people what we know for sure and let people make decisions based on that. The trouble is, it is the most fundamental question of all (how markets work) that causes the most uncertainty. Buy-and-Holders believe that the market is efficient. If that’s so, stock investing risk is stable and staying at the same stock allocation at all times is the ideal strategy. But what if this is not so, what if valuations affect long-term returns? If that is so, then risk is variable and Buy-and-Hold is the most dangerous strategy imaginable (if millions of investors elect to remain at the same stock allocation when they should be lowering their stock allocations to keep their risk profiles constant, the collective losses will be in the many trillions of dollars and will cause an economic crisis and in time a Second Great Depression).
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So which is it? As a society, we do not know. My belief is that valuations affect long-term returns, that the market is NOT efficient. But there are millions of good and smart people who believe just the opposite, who believe that Buy-and-Hold is a 100 percent sensible and responsible strategy. So, in the practical realm what do we do? We cannot tell people to hold off on investing for retirement until we all agree on which approach is best. Given that we do not all agree what is best, what should we tell investors to do?
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It seems to me that the presumption should be that valuations affect long-term returns. All that long-term timing is is paying attention to price. There is no other good or service that we can buy for which price does not matter. Why presume that stocks are the one exception? Plus, we have the fact that for the 140 years of historical data available to us, price always HAS mattered; the data confirms what common sense tells us must be so. In contrast, Buy-and-Hold has never worked in the long-term. Those who stay at the same stock allocation always face a wipeout sooner or later; prices gradually rise higher and higher and higher (because so few are paying attention to price!) and eventually the market crashes and we all lose (even those not invested in stocks suffer in the economic crisis brought on by the huge loss of collective wealth experienced in a stock crash).
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I believe that the Efficient Market Hypothesis was a powerful insight containing one huge flaw that is now in the process of killing us. The hypothesis ASSUMES investor rationality. Shiller’s research shows that investors are NOT rational. What fools people is that the irrationality of investors does not do us much harm in the short-term. From 1982 through 1996, stocks were priced to provide a strong long-term value proposition. Buy-and-Holders were going with high stock allocations for different reasons than Valuation-Informed Indexers but the practical effect (good returns) was the same for both groups of investors. It was only with the 2008 crash that Buy-and-Holders were able to see in a concrete sense the danger of staying with the same stock allocation at all times (and of course the next crash — Shiller’s work suggests that prices will drop another 65 percent over the next few years — will bring the point home in a truly terrifying way).
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The Buy-and-Hold Model (rooted in a belief in the Efficient Market Hypothesis) permits researchers to study all aspects of the investing experience that can be examined through the use of logic. But the the most important thing we need to study is RISK and the risk of stock investing is rooted in the human inclination to let emotion influence one’s allocation choices. We need to give ourselves permission to discuss RISK in a frank way and that requires that we talk about things not acknowledged by the Efficient Market Hypothesis. The P/E10 metric is a tool that lets us reduce investor emotion (risk) to a number. Stocks were priced at three times fair value in 2000, according to the P/E10 metric. This means that the investor who thought that he had a portfolio value of $600,000 in reality had a portfolio value of $200,000. Big difference! That investor’s illusions caused him to make all sorts of bad financial planning decisions. Those illusions caused him to ruin his life. But the researchers in this field never talk about that aspect of the question! They talk about numbers. To understand investing, they need to talk about human emotions. It is the human desire for self-deception that is the driving force behind all bull markets and it is bull markets that make stock investing risky (there has never been a price crash of long-term significance starting from a time when stocks were selling at low or moderate prices).
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The problem we have is a circular one. The experts say that Buy-and-Hold can work because this is what people want to hear. And the people want to hear it because in an earlier time they were persuaded by the experts that Buy-and-Hold could work and now their retirements are riding on it. How do we break the circle? The researchers should be warning people of the dangers of Buy-and-Hold in a world in which the Efficient Market Hypothesis has been discredited (if Shiller is right, the Efficient Market Hypothesis is wrong). Most are not doing this. When researchers fail to point out the dangers, people assume that the advice they are hearing from the experts must be more or less okay. In reality, it is as dangerous as all get-out. The researchers are not paying attention to how their research is being used — it is being used to prop up long-discredited (even if once promising) ideas.
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Here is a blog post in which I report on an e-mail I received from Rob Arnott:
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I find it a scandal that researchers were intimidated into not doing research they believed was important. How can we advance knowledge if we are afraid to look at the most important questions? Who is it that is sending the hate mail to these journals? Scientists? Is the sending of hate mail part of the scientific process?
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These sorts of things don’t happen only to Rob Arnott. When I was working with Wade Pfau, he was like a kid in a candy store, discovering new insights on a daily basis and getting more and more excited about where he could go with them. Now he feels that he dare not explore any of those insights. Please look at the quotes at the bottom of this article (the longer version of the article I linked to in my first e-mail to you)
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and see what Wade said about the work he was doing at the time. He was AMAZED that no other researchers had engaged in these sorts of explorations. He couldn’t make sense of it. Now he knows. Other researchers don’t look at these questions because it is a career-limiting move to do so.
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Even Robert Shiller has experienced intimdation. Shiller has said in interviews that he has never told us all that he knows about how stock investing works because he knows that he would be branded “unprofessional” if he were to do so. Huh? An economics professor at Yale doesn’t feel comfortable sharing what he knows about a critically important subject that he has studied for decades? How could that possibly be a good thing? How could such intimidation tactics be part of a valid scientific endeavor? Intimidation tactics are not science. Intimidation tactics are the antithesis of science.
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I believe that this article
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is one of the most important “studies” even done in this field. Most people in this field won’t even refer to it as a “study” because it does not contain numbers and charts and tables. I say it is important because it tells the true story of the EMOTIONS of the Buy-and-Holders. That’s what we need to know about to advance our knowledge. That’s the missing piece. The market really does want to be efficient. Fama was close to getting it right. What he missed is that investors can behave rationally only if they have access to all the information they need to make good decisions. And, once we get into a bull market, as a society we formulate a SOCIAL TABOO that blocks us from engaging in discussion of the problems of overvaluation. We “know” that the inflated prices are real at the same time that we also “know” on another level of consciousness that they are not. The conflict between the two things we “know” drives us crazy and we evidence our craziness in the sorts of comments you see recorded in that article.
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I hope that I am making at least a little bit of sense, Valeriy. I am grateful to you for giving me an opportunity to at least take a stab at making sense to a kind and intelligent person who is well-informed about these issues.
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I do believe in a sort of conspiracy. But it is not the sort of conspiracy in which bad people meet in a smoke-filled room to craft plans by which to screw people over. It is a Conspiracy of Ignorance in which millions of people who deep in their hearts very much want to move on to a better place hold back from doing so because they are afraid of what they will find on the other side of The Big Black Mountain. I have been to the other side and I am here to report back that there are wonderful things to be found on the other side. My problem is that it is hard to convince people who have never seen these things how much we are able to advance our understanding of how stock investing works today. We now know how to make stock investing a virtually risk-free endeavor. Wade’s research shows that the Maximum Portfolio Drawdown Percentage drops all the way down from 60 percent to 20 percent (with no loss of return!) for those investors open to taking valuations into consideration when setting their stock allocations. We are on the verge of experiencing the greatest advance in our understanding of how stock investing works ever experienced in history.
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All we need is for people to calm down and let in all the good stuff. But people are afraid of the new. I can comfort them and reassure them and inspire them if I can talk to them. But the Buy-and-Hold dogmatics go crazy with fear whenever and wherever I try. And they use the studies of the academic researchers to justify their use of their intimidation tactics. So I need to report to the people affected by this (that’s every last one of us!) how the academic research is being used. It is being used today not to advance knowledge but to hold it back from advancing! I need to say that not because I do not like the researchers (I like them very much) but because it is so and because the intimidation tactics have brought on an economic crisis and because we must address this problem if our free market economic system is to survive.
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That’s where I am coming from, in any event. I hope that my venting has made at least a tiny bit of sense. Please do not think that in any way, shape or form I am aiming to criticize you personally. We are all (including me!) little parts in a big Machine. My job is to get that big Machine back on the right track so that all our work becomes productive and positive and meaningful and life-affirming and fun again. It’s a very hard job but it very much needs to be done and through a strange twist of events it seems that I was elected to take this one on.
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Please let me know of any thoughts that these words inspire. If I am off-base, I very much need to know how.
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Rob
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ADDENDUM A:
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On reading these words back, I see that I did not address your final point, that a move to money markets would cause a collapse. It’s true that a move out of stocks would cause prices to fall to fair-value levels and that that would be a significant drop from where we are today. The good news is that, once we let people learn how stock investing really works, we will never again see a drop below fair-value levels. In a rational world in which knowledge can be shared freely, stock prices are self-adjusting. High prices cause the value proposition of stocks to fall, which causes people to want to lower their stock allocations, which causes prices to return to fair-value levels. There never again will be bull markets or bear markets once we open the internet to honest posting on the implications of Shiller’s findings.
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The emotional approach (Buy-and-Hold), however, eventually causes prices to fall to levels far BELOW fair-value levels. Every secular bull in history has eventually brought us to a P/E10 level of 7 or 8, a 65 percent price drop from where we are today. Insane emotionalism in one direction always brings on insane emotionalism in the other direction. What we want is emotional (and market) stability and that can only be brought on by addressing the emotional conflict that I referred to up above. People will feel at ease about stock investing when they understand how it works and people will understand how it works when we produce lots of research showing that buying stocks is just like buying any other good or service, the price you pay ALWAYS, ALWAYS, ALWAYS matters. It is emotion that causes risk. And it is the belief that it is possible to invest in stocks successfully without taking price into consideration that causes emotion (no human is capable of having confidence in a strategy that ignores price because it defies common sense to believe that price might not matter).
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We WILL see a price drop if we open the internet to honest posting but it will be limited. The huge price drop we will see if we continue the cover-up will bring on the Second Great Depression. We can recover from a relatively small price drop and our new knowledge of how to make stocks a virtually risk-free investing class will then bring on an economic boom as millions of middle-class people learn for the first time how to finance their retirements in a truly smart, simple and safe way.
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ADDENDUM B:
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What I am suggesting re the “How Science Works” question is that the default belief be that price DOES matter, that long-term timing IS required. Price matters with every other good or service offered for sale. Why ASSUME that it works the other way around with stocks? If that were the assumption, people could still publish research trying to show that Buy-and-Hold works, but the default belief would be the opposite of what it is today. If people concluded that there was good evidence in both directions, they would go with a belief that the case for Buy-and-Hold (or the case for market efficiency) had not yet been made and that thus it was not appropriate to suggest that such a strategy could work. The root of all our troubles is this crazy assumption. There has never been a single study showing that long-term timing doesn’t work and common sense tells us that it MUST work. Why assume the opposite of what both common sense and the entire record of historical data tell us and then become dogmatically opposed to challenges to the crazy assumption?
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To make sense of this, I think we need to go back to the days when the Efficient Market Hypothesis was developed and examine why the mistake was made. My sense is that the problem is that index funds were not available at the time (Bogle formed Vanguard in 1976). Long-term timing only works with indexes. Since indexes were not available when the work was being done to see whether timing works or not, the researchers tested only short-term timing. When they learned that short-term timing doesn’t work, they jumped to a hasty conclusion that both forms of timing do not work (because in a practical sense there really was only one form at that time). It is my belief that, had Shiller published his “revolutionary” (his word) findings in 1971 rather than 1981, the name of the 1974 book would have been “A Valuation-Informed Walk Down Wall Street” and we today would be living in the greatest period of economic growth in our history instead of in the early years of the Second Great Depression. You see concern expressed about the national budget deficit all the time. But if you compare the numbers, the Buy-and-Hold problem is the far more serious one (the market was overpriced by $12 trillion in 2000 and even Bogle acknowledges that prices always return to fair-value levels with the passage of about 10 years of time — it is obviously not possible for any economy that loses $12 trillion of buying power in 10 years to avoid collapse).
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ADDENDUM C:
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My bottom line is that we all need to work together to launch a national debate on these questions. I obviously do not know it all. I obviously am one of the flawed humans. So anyone who goes solely by what I say is a darned fool. But what if there were thousands of people coming from all sorts of different perspectives and from all sorts of sets of life experiences addressing these questions with clear and frank and honest words? I think that would turn all this negative energy into positive energy. Say that Buy-and-Hold prevailed. That would be wonderful! By permitting the debate, the Buy-and-Holders would end up for the first time feeling a true confidence in their ideas. We should all want to see that happen if the reality is that Buy-and-Hold works.
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I don’t believe that it is even possible for people to know something that they do not feel free to talk about. We learn through discussion. So we MUST talk openly about these matters. It is this assumption that the market is efficient despite the 30 years of academic research showing otherwise that keeps people from talking openly. So I believe that that assumption must be challenged. I believe that we should give Fama full credit for his contribution, which was huge. But I also believe that Fama himself wants his ideas to bear good fruit and so on some level of consciousness Fama himself (and all those who follow his ideas) wants learning to advance. If Fama and Bogle and all the others on “that side” of things wants learning to advance, we ALL want learning to advance. So let’s do it! Let’s get about the business of learning together what really works! We should put an end to The Debate About Having a Debate and proceed to the actual debate that matters, the debate about how stock investing works in the real world.
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Rob

Economics Professor Valeriy Zakamulin: “We Cannot Assume the Existence of Predictability Just Because There Are No Studies That Fully Reject It”

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I’ve been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on a response that I received from Valeriy Zakamulin, a professor in the Department of Economics and Business Administration at the University of Agder, and my reply to that response.

Valeriy then wrote:
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Dear Rob,

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There are currently a few working papers that explore how to use the Shiller’s PE ratio for long-term investing, see for example

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http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2129474

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http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2031406&http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2031406

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In financial industry there have been developed market indexes to facilitate the implementation of the Shiller’ idea, see for example

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http://www.indexuniverse.com/sections/news/14498-barclays-shiller-hatch-pe-linked-indexes.html

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When it comes to your question “Do you know of any that show the opposite — that long-term market timing does NOT work”, you see, science is not the law where there is “presumption of innocence”. That is, we cannot assume the existence of predictability just because there are no studies that fully reject it. Besides, there are many different forms of predictability, many signals/variables/models that can be used. In science one first introduces a hypothesis and then test it. Thank god we have the Efficient Market Hypothesis! This provides us with a very simple benchmark to test different deviations from the EMH. Usually in science one first publishes a paper that shows evidence of predictability (using for example a specific signal/variable/model), then, if researchers finds some flaws in the paper, they publish papers that demonstrate these flaws and what happens if one takes into account these flaws.

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How science works, see for example

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http://en.wikipedia.org/wiki/Karl_Popper

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It seems to me that you believe in some sort of “conspiracy”, that the majority of academic researchers deliberately support the faulty idea of superiority of Buy-and-Hold strategy. May be a few of them do, mainly because there have studied it, and we lecturers tell about it, sometimes without due critique. But it seems to me that the buy-and-hold strategy is mainly supported by industry practitioners who earn money by investing other’s money in stocks. Their salary depends on how many people invest in the stocks, no matter the long-run outlook, whereas a salary of an academic researcher is not.

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On the other hand, let us assume that everybody uses a market timing strategy that works. Then imagine what happens with the stock market and economy when everyone sells stocks and switches to money markets. There will be a total financial disaster and long-term economic collapse! Will people be better off? I doubt. Have you ever thought about this?

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Valeriy

Economics Professor Valeriy Zakamulin: “I Would Not Agree That All Academic Professors Deny the Existence of Predictability. If A Paper That Supports Predictability Is Not Accepted, This Usually Does Not Mean That an Editor or a Reviewer Disbelieves In It. Most Often There Are Some Serious Flaws in Research Design.”

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I’ve been sending e-mails to numerous people, letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Valeriy Zakamulin, a professor in the Department of Economics and Business Administration at the University of Agder, wrote:

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“I agree that the topic of stock return predictability is indeed controversial. Yet I would not agree that all academic professors deny the existence of predictability. If a paper that supports return predictability is not accepted, this usually does not mean that an editor or a reviewer disbelieves in it. Most often there are some serious flaws in research design. Typical flaws are data-mining bias, look-ahead bias, econometric pitfalls, etc. There have been published many papers in top academic journals that find in-sample predictability.”

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Personally I believe in stock return predictability, see my paper

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http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1857794

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I replied:
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Valeriy:

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Thanks a million for that extremely helpful response.

One, I appreciate the context you provided re why some research in this area may have been rejected. There are some who adopt views re this matter that I view as excessively cynical. It cheers me to hear someone who is more knowledgeable than me about the technical aspects of the question who is able to offer a more charitable and encouraging and positive take.

Two, I did not know about your research and I am so happy that now I do! I have downloaded the paper and will give it a careful read over the next week or so (I am at the moment trying to complete a few projects I need to put behind me before taking a few days off for the holidays).

I am not an investing expert. I do not have the technical background you possess. I am a journalist. I do think I possess a strong grasp of the political aspects of the question (as noted above, I tend to be inclined to a more optimistic take than some of the others who share my concern that we need to move forward more quickly than we have been re challenges to the conventional thinking). I also have done a lot of work exploring the how-to-invest implications of Shiller’s findings and the research that followed from it. Please feel free to shoot me an e-mail if you ever have an interest in talking over any questions re which you believe that I might be able to offer any help.

I’ll ask you one question that I think is key to making sense of all this. Please don’t feel that I am demanding or even expecting an answer for you. I am just throwing this question out there in the event that it might be helpful to do so.

You say that there are many papers in top journals showing in-sample predictability. Do you know of any that show the opposite — that long-term market timing does NOT work? My sense is that the source of all the confusion is that those who believe in the Efficient Market Theory ASSUMED that long-term timing does not work without ever showing this to be so and that the problem ever since has been that people don’t want to reject this assumption because so many books and articles and calculators were built on this foundational belief.

The idea that timing doesn’t work became the default position, so the burden was placed on those who believe in predictability to prove their case while it really should be the other way around — we should be assuming that long-term timing always works (since long-term timing is paying attention to price and price discipline is what makes markets work) and challenging those who do not believe that long-term timing is required to present evidence in support of their case.

IS there any evidence that supports the claim that long-term timing is not required? Wade Pfau spent a good bit of time trying to find something re this point and came up empty-handed. He even went to the Bogleheads Forum and asked if anyone there knew of any studies showing that long-term timing does not work or is not required for long-term success. No one there knew of any work that had been done on this particular point.

Thanks so much for doing the work you do, which I believe (I am biased — but still…) is the most important research work (in any field!) being done today. I wish you the best of luck in all your future endeavors.

Rob

25-Year CPA Lyn Graham: “One Direction for a Person Working With Such Perceived Threats Is to Work Under the Visible Level. The Other Is to Be Very Visible and Make It Difficult for the Threats to Be Carried Out Without Notice.”

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I’ve been sending e-mails to numerous people, letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with 25-Year CPA Lyn Graham. Set forth below is Lyn’s response:

The forthcoming market crash is foretold and purposeful, and no investment strategy I have heard or can think of is the solution. It is a sad state of affairs. Reagan warned we are only a generation away from losing our freedoms. I never took that as a prophesy but ….
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Economic success breeds freedom, and economic success is being destroyed, purposefully.
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One direction for a person working with such perceived threats is to work under the visible level. The other is to be very visible and make it difficult for the threats to be carried out without notice.
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I am not sure I have much to add. Good luck.
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I replied:
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Lyn:

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I’ve definitely chosen the “Be Very Visible” path!
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I want to end the conversation on an optimistic note. Shiller’s ideas represent a very big advance. I truly think I speak as an expert on this question because no one else has spent as much time exploring the implications of his ideas. Think where we would be had we failed to achieve any advances in electronics and computer and software technology for the past 32 years. We’ve given up a lot by closing off advances in our understanding of how stock investing works. The good news is that, when those paths open to us, we are going to see huge increases in our economy’s ability to generate wealth for us all in a very short amount of time.
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I am not saying that everything is roses. But I think that sometimes it is darkest before the dawn and I don’t think that is pure coincidence. I think it may sometimes take a spell of darkness to help the humans appreciate why it is important always to be moving ahead. I can see things getting much worse than they are today and then suddenly turning very positive indeed.
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Even if I am wrong, it’s probably better to be optimistic than not to be as it is difficult to work up the energy to work hard for good solutions once one becomes overly pessimistic. If it were just me, perhaps I would become discouraged. I have two young boys. So I feel that I have no choice but to maintain hope for the future even when my eyes see things that otherwise might push me in the other direction.
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Rob