A Rich Life

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

“I Definitely Need to Cite [You] as the Founder of Valuation-Informed Indexing…. Shiller Pointed Out the Predictive Power of P/E10 But Never Discussed How to Incorporate It Into Asset Allocation.”

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Yesterday’s blog reported on an e-mail that I sent to academic research Wade Pfau on January 16, 2011. Wade responded later the same day. He endorsed John Walter Russell’s characterization of a paper purporting to show that long-term timing does not work as testing “idiot switching.” He said: ” ‘Idiot switching.’  That is great, and describes exactly what the Fisher and Statman paper does.  You and John have a great knack for coining new terms.  I think VII is a much better term than any alternatives I’ve come across.” He added that he did not think it would be appropriate to use the term “idiot switching” in an academic paper.

Wade also reported that “as always, I will be reading all your links.” He said: “I definitely need to cite some of your work as the founder of VII, as I have not found anyone else who can lay claim to that.  Shiller pointed out the predictive power of PE10 but never discussed how to incorporate it into asset allocation, as far as I know.”

 

“This Is the Paper That Prompted John Walter Russell to Coin the Term ‘Idiot Switching’ “

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Yesterday’s blog entry reported on an e-mail sent to me on January 16, 2011, by academic research Wade Pfau. Set forth below are the texts of my three response e-mails.

Wade:

It’s always nice to hear from you. I am doing fine. Thanks for your kind comments re the podcast. I haven’t looked at the linked paper but I will look at it shortly.

Please ask any questions that happen to come up. I may or may not be able to help with them. If I am not, you will be helping me by leading me to discover holes in my thinking. That’s obviously important.

Your interest in the general subject encourages me. As you know, I have been walking this path for a long time. I was pulled onto it not out of a personal desire but as the result of a strange set of circumstances. As I continued down the path, I discovered more and more tentative findings that seem to me to offer great promise. So I have not been able to give up the effort either to disprove or affirm the basic concept.

In ordinary circumstances, this would be easy to do. But my experience has been that even many smart and good people do not want to look too closely even at tentative findings that suggest follow-up findings so far removed from the conventional wisdom of our day. So I have been frustrated in my effort either to convince myself that the ideas are not worth pursuing or to convince enough others that they represent genuine advances  to get them the attention that they merit in the event that they are sound.

Any work you are able to do re these ideas will obviously help move the ball forward a bit. So I am happy that you are evidencing a good bit of interest. I will always be happy to help in any way I can whether that means that the ideas become better known or that they become discredited. The important thing is that the ideas either be advanced or killed based on the extent to which they do a good job of describing the realities.

Please take whatever time you need before moving to the next step in your explorations. It is clearly more important to get each step right than to move through many steps at a quick pace.

Thanks for bringing a measure of cheer and optimism to my Sunday morning!

Rob

Wade:

I pulled up the paper.

I only took a quick look because I recall that one coming up in a discussion that was held at the Vanguard Diehards board at the time the paper was published. My recollection is that this is the paper that prompted John Walter Russell to coin the term “idiot switching.” I haven’t spent enough time with the paper to refresh my memory re their methodology but my recollection is that they did not do things in the way in which someone trying to make the strategy work would do things. The put the non-stock money in unnecessarily low-earning asset classes and I believe that they often made extreme shifts (from very low stock allocations to very high stock allocations) in response to modest P/E10 changes (I am not even sure if they always used P/E10 — it may be that they were using P/E1, which is far less reliable). I recall not being impressed by that paper when it came out.

Rob

Wade:

I have two articles at my site that link to studies on the VII topic. As a journalist, I follow a broad interpretation of the word “study” (I am open to using anything that effectively makes the point). So it may be that these two articles will not be of value to you. But it is possible that one of the links or one of the excepts will lead you to something of use. So I thought I would pass these along.

http://www.passionsaving.com/buy-and-hold-is-dead-part-one.html

http://www.passionsaving.com/buy-and-hold-is-dead-part-two.html

Also, here is an article linking to 20 quotes that I collected making the essential point. I think it makes a compelling case to read all these comments in one place:

http://www.passionsaving.com/buy-and-hold-investing.html

Rob

Academic Researcher Wade Pfau: “As You Say in Your Podcast, Valuation-Informed Indexing Should Beat Buy-and-Hold About 90 Percent of the Time, and I Am Getting Results That Support This”

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I received an e-mail from academic researcher Wade Pfau with the title “Valuation-Informed Indexing” on January 16 2011. Wade told me that he had listened two times to the RobCast in which I outline nine possible Valuation-Informed-Indexing portfolio allocation strategies and characterized it as “excellent.” He said: “I wrote up the programs to test your VII strategies against buy-and-hold, and I must say that the results look very promising…. I am quite excited about the findings so far.  As you say in the podcast, VII should beat buy and hold about 90 percent of the time, and I am getting results that support this for various strategies.”

Wade wrote that he had only been able to find one paper in the literature “which tests something even remotely close to Valuation-Informed Indexing.” This was a paper by Kenneth L. Fisher and Meir Statman titled “Market Timing in Regressions and Reality.” Here is a link:

http://ww.scu.edu/business/finance/research/upload/mkt-timing-in-regression-and-reality-2.pdf

Wade said that he would be criticizing the paper in one of his own forthcoming research papers.

He concluded by saying: ” I hope to have a finished paper in a month or so.  I think I may need to ask you a few questions before finishing, but I still have to work my way through all the materials you already sent me.”

“The Regulars (at the Bogleheads Forum) Did Not Want This Message (That the Old School Safe Withdrawal Rate Studies Get the Numbers Wrong) Being Heard Because of the Board’s History re This Message”

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Yesterday’s blog entry reported on an e-mail that I received from academic researcher Wade Blog on January 5, 2011, in which he expressed the view that an appropriate title for a thread at the Bogleheads board would be “Yes, Virginia, Valuation-Informed Indexing Works!” My response is set forth below.

Wade:

I obviously would love to see you use that title, Wade. And I think that would do a lot to move things in a positive direction.

As I am sure you understand, there are some delicate matters in play here. I am of course grateful for anything you are able to do to open things up and I will of course participate in a constructive way to the extent that it ever becomes possible to do so.

People are defensive and embarrassed (and even ashamed and even fearful of facing legal liabilities). I think that’s the true reason why there were so few views on your third thread. What usually happens in that a few of the regulars posts to a thread and then the far larger number of non-regulars feels comfortable joining in. In the case of that third thread, the regulars did not want this message being heard (because of the board’s history re this message). So they let the thread die. There was a day when every SWR thread got HUNDREDS of posts in that community.

It has never been my intention to make anyone feel bad. That community has huge potential. I have learned a great deal from lots of people there and I have lots of friends there who have said many kind thing about me and my work. The problem is that some have taken dogmatic positions and feel that they cannot back down no matter what. I believe that everyone should be expressing his or her sincere views, but “everyone” obviously includes me and the others who believe that valuations affect SWRs.

I believe that it will all get worked out in the end. The sooner that happens, the better it will be for every single person involved. But there are limits to what I can do to make good things happen. I need to wait for events to turn in a positive direction. When that happens, I will be doing all that I can to bring things to a better place for every single person involved.

Rob

Wade Pfau: “Yes, Virginia, Valuation-Informed Indexing Works!”

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Yesterday’s blog entry reported on an e-mail sent by academic researcher Wade Pfau to me on December 24, 2010. We exchanged several brief e-mails in the following days. The next substantive one was one that Wade sent me on January 5, 2011, in which he recommend that I read the book “Yes, You Can Time the Market!” by Ben Stein and Phil DeMuth because “it vindicates your views about using valuations to guide long-term conservative investors.” My response is set forth below.

Wade:

It’s always good to hear from you. Things are going well with me.

I have read the book. My favorite part is the introduction. Stein there explains what got him started on the path that led to him writing the book. What got him started was the commonsense observation that timing just had to work — for timing not to work would mean that the price we pay for stocks makes no difference in the results that we obtain and that simply cannot be so.

This is a two-step process. First, one has to be persuaded that timing must work. Then one must go about finding the best approach to timing.

On the first question, I am persuaded that we know the right answer –we know that timing works because it is not possible for the rational human mind to imagine a universe in which the price paid for something does not matter. On the
second question, we need to explore lots of possibilities. It’s not possible for us to know anything with much confidence until there has been extensive public debate on numerous possibilities and we are just not there yet. To get that debate, we need to persuade the Buy-and-Holders to ease up on their dogmatism enough to permit a variety of viewpoints to be widely heard.

The focus on 1984 and 1985 is important. I think that the way the price signals work is indeed the flaw to their particular approach.

There is no one P/E10 level at which stocks turn good or bad. People need to understand that the value proposition gradually changes. Any cliff approach is going to fail in some circumstances.

Say that we were trying to say what the perfect highway driving speed is. Some would say “55,” some “60,” some “70.” Some would say “80”! And, if you tested this, you would find that sometimes driving 80 does not lead to an accident. And sometimes someone driving 55 gets in an accident. There is no one correct driving speed. It does not exist.

It does not follow that we should not have speed limits. We must have a speed limit. We know that the danger of driving increases as speed increases. So we just need to reach a consensus that it is okay to drive 65 but not 70 and go with that even though we understand that there is something artificial in setting the speed limit at any one particular number.

This is how it works with stocks. Stocks are more risky when the P/E10 is 15 than they are when the P/E10 is 10. And 20 is worse. And 25 is still worse. And 30 is still worse again. But there is no one magic number. If you say “Sell all your stocks at 30,” you are going to be proven wrong in the eyes of some when the P/E10 continues up to 44, as it did in January 2000.

We need to separate out the things we know (stocks get increasingly risky as the P/E10 level gets higher) from the things we do not know (the precise P/E10 level at which people should sell stocks). What we really need is a change in the way we talk and think about stock investing. We need to become confident enough to make measured statements.

Buy-and-Hold is inherently dogmatic (it posits that there is never a need to make any allocation change). I think this dogmatism has its roots in fear. Investing is so important to us that we demand a level of precision in our pronouncements that it is impossible for us to achieve today. We need to just relax a bit, let in different viewpoints, and stop feeling a need to come up with perfect answers to every question (Buy-and-Hold does not do this, so we should not demand that alternatives to Buy-and-Hold do it either).

We will never come up with perfect answers. The reason why is that there are always two opposite sorts of factors affecting stock prices. There are economic factors, which are highly predictable. And there are emotional factors, which appear to be almost entirely unpredictable. To not make any predictions at all is foolish because the effect of the economic factors is predictable and being able to predict returns reduces risk while increasing return. But to make precise predictions is ALSO foolish because the emotional factors are almost entirely unpredictable and will cause precise predictions to fail regularly.

What we can do is to identify a RANGE of possible long-term returns and assign ROUGH probabilities to each point on the spectrum of possibilities. This is of HUGE value. The Return Predictor tells us that, for stocks bought when the P/E10 is 10, there is a 50 percent chance that you will be seeing a 10-year annualized return of greater than 10.7 percent real and that, for stocks bought when the P/E10 is 20, there is a 50 percent chance that you will be seeing a 10-year annualized return of less than 3.0 percent real. This tells us a lot about how much risk applies in these two different scenarios.

But it does not tell us everything. With a super good returns sequence, you could buy stocks at a P/E10 of 20 and get a 10-year annualized return of 9 percent real. With a super bad returns sequence, you could buy stocks at a P/E10 of 10 and get a 10-year annualized return of only 4.7 real.

No one knows in advance what returns sequence is going to come up. This is determined by investor emotion, which cannot be predicted. We should be making use of what we do know (that stocks carry more risk at higher valuations) while
not pretending that we can know things we cannot know (things that we would need to know to make precise predictions).  We CAN time the market, but only in the long-term and not in such a way as to permit precise knowledge of market
tops and bottoms.

Wade sent a brief response later that day expressing surprise re how few views there were at the Bogleheads board for a thread he put up on the effect of valuations on safe withdrawal rates and saying that, based on the research he was doing, he was giving consideration to going with the following title for his next thread-starter at the Bogleheads Forum: “Yes, Virginia, Valuation-Informed Indexing Works!”

Rob

Wade Pfau: “I Hope We Can Stay in Touch. I Would Like to Do a Valuation-Informed Indexing Study, But It Will Probably Take a Few Months Before It Gets Finished.”

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Yesterday’s blog entry reported on an e-mail that academic research Wade Pfau sent me on December 16, 2010. I sent my response on December 24, 2010. The text is set forth below.

Wade:

I have a few minutes today to write up some responses to this e-mail, which I didn’t get to write up when I first received it. I hope you are enjoying your holiday and I of course understand that you may not be able to look at this for some time.

You asked about citations. I thought your linking to the Google Knol was a good choice. That provides an overview of the New School SWR approach with links to additional materials for those who want to explore deeper. There’s one big problem with linking to the Knol, however. My sense is that Google may pull the plug on the Knol site at just about any time. So it may be that the link will not work for long. My second choice would be to link to the calculator page as
that contains both the essential tool and links (when you scroll down the page) to more materials.

http://www.passionsaving.com/retirement-calculator.html

You asked about the timing of John’s essential findings. I’ll provide some links to the SWR Research Group, a forum that I founded in July 2003. John did much of his research there and others commented on it in real time (the comments often led to further research). Unfortunately, abusive posters insisted that the board (and the entire site at which it was housed) be shut down. After it was shut down, one of the abusive posters  put the board back up (without acquiring rights to the material) and added some abusive introductory material. It does not appear to me that the posts themselves were doctored. I understand that you may not want to cite to a source with abusive material in it.
But these links will at least address the timing question you had. And there is a lot of material at this board that you may want to at least know about. When it comes to providing a link, you might link instead to the www.Early-Retirement-Planning-Insights.com site. John reposted much of the material first produced for the SWR Research Group board at his own site (which passed to me on his death).

Here’s a thread that John posted on July 24, 2003 called “Safe Withdrawal Rate vs. P/E10 Data.” He would have described this as the date at which he felt confident enough that a valuation adjustment is needed in SWR research to have characterized research not containing a valuation adjustment as “analytically invalid.” I had been using that term for some time at this point.

http://s162532268.onlinehome.us/Sewer/viewtopic.php?t=1169

Here’s a thread that John posted in March 2005 called “Our Standard Analysis Procedures.” This describes his methodology.

http://s162532268.onlinehome.us/Sewer/viewtopic.php?t=1042

You asked for recommendations re what to read re the work that John and I did together. I would suggest starting with the material at the Foundations section of his web site:

http://www.early-retirement-planning-insights.com/foundations.html

I hope this material helps a bit. Please let me know if you have questions about any of it.

Rob

Wade responded later the same day. He said: “I hope we can stay in touch.  I would like to do a VII study, but it will probably take a few months before it gets finished.”

Wade Pfau: “I Was a Little Nervous About Contacting You, In Case You Thought I Was Trying to Steal Your Thunder”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on December 21, 2010. Wade was visiting family for the holidays at that time. So that series of e-mails came to an end. The topics discussed in it were picked up in subsequent e-mail discussions.

One separate discussion grew out of some matters brought up in the discussion thread referred to above. The focus of this discussion was a research paper that Wade prepared on safe withdrawal rates. Set forth below is the text of an e-mail that I sent to Wade on December 16, 2010, relating to his safe withdrawal rate research.

Wade:

That’s super! Thanks so much for letting me know.
I skimmed the paper before writing to you. I will read it more carefully perhaps tomorrow (I have a few deadlines facing me today). I’m excited to see this. I am so glad that you let me know about it.
I am going to post your comment as today’s post to my “A Rich Life” blog. I’d love to see more people doing this sort of thing.
I’d be grateful if you would let me know when the article is published. It’s of course my belief that this is important stuff and we need to see lots more good and smart people advancing the ball in the way in which you have with this work.
Rob
Wade responded the same day. He said: “I was a little nervous about contacting you, in case you thought I was trying to steal your thunder.  I did try to properly cite your contributions.  I’m glad to see your positive response.”
Wade asked how he should cite the work John and I did together during the time we were developing The Retirement Risk Evaluator, in particular a post by John in which he described his approach on confidence limits. He observed that: “You’ve written so much that I’m afraid I’ve only read a small sample of it all” and urged me to identify some of my writings that would be of particular benefit to him.
He provided me links to two research articles he had written on safe withdrawal rates.

Wade Pfau: “If Valuation-Informed Indexing Consistently Outperforms Fixed and Lifecycle Strategies, Then the Proof Is In the Pudding. Given How Well Valuations Help to Explain Withdrawal Rates, I Think There Is a Lot of Potential for This Topic”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on December 19, 2010. Wade sent his response the following day.

Wade said: “‘I’m excited about this, as depending on what you have already done, I think I can design a study using the Shiller data to provide historical simulations of VII strategies against fixed buy-and-hold strategies and also lifecycle strategies (declining allocation to stocks as one ages).  If VII consistently outperforms fixed and lifecycle strategies, then the proof is in the pudding so to speak.  Given how well valuations help to explain withdrawal rates, I think there is a lot of potential for this topic.”

He added that Monte Carlo simulations do not work in this area because “the assumptions built into their design will mean that valuations do not matter by definition.” He argued that this type of study can only be done with historical data and speculated that using Monte Carlo simulations may have thrown some researchers off the right track.

Wade also suggested that different types of investors might want to follow different allocation-change rules. “There are lots of possibilities,” he said.

My response is set forth below.

Wade:

All that sounds super.

You may want to take a look at the analysis/graphics set forth at this link:

http://www.financialwebring.org/forum/viewtopic.php?t=106998

This examination of how Valuation-Informed Indexing has performed historically was done by Norbert Schenkler, a part-time financial planner and co-owner of the Financial WebRing Forum. He is a long-time abusive poster at numerous boards but it appears to me that he was playing it straight in preparation of this analysis.

He says: “The evidence is pretty incontrovertible. Valuation-Informed Indexing is…everywhere superior to Buy-and-Hold over ten-year periods.” The one exception he finds is the late 1990s. But that is no longer an exception since the crash
(the analysis was prepared pre-crash).

John and I prepared a calculator called “The Investor’s Scenario Surfer” that permits a Monte Carlo testing of possible 30-year return sequences so that investors can compare how they would have done with VII vs. how they would have done with 80 percent reebalancing, 50 percent rebalancing and 20 percent rebalancing:

http://www.passionsaving.com/portfolio-allocation.html

The Monto Carlo used here is a bit different from what is usually used in that it contains filters that cause the results to show a valuations effect (going-forward returns are higher starting from low-valuation starting points).

I am not advocating either Monte Carlo or actual historical data. Some view the actual data as more real. But some others argue that 140 years of data is not enough to draw definitive conclusions. I personally like the filtered Monte Carlo approach. But it makes sense only for those who already buy into the idea that valuations affect long-term returns, so I think it could be argued that in a sense it begs the question. My aim here is just to let you know about what I know that has already been done so that you can review if before choosing your own path.

My experience with the Surfer is that VII produces the best 30-year results in about 90 percent of the return sequences generated. 80 percent rebalancing almost always places second, 50 percent almost always places third, and 20 percent rebalancing almost always places last.

There’s a pattern that applies in most runs that explains why VII usually ends up ahead. It sometimes takes only a few years for VII to go ahead and it sometimes takes many years. But this almost always happens at some point in a 30-year cycle (in every 30-year cycle in the real world, we have had one occasion when valuations were dangerous). Once VII goes ahead, it becomes impossible for 80 percent rebalancing to catch up because VII and Buy-and-Hold both call for high stock allocations at moderate and low valuations. And the compounding effect causes VII to go farther and farther ahead over time.

The thing that make the difference as to whether VII wins by a little or a lot is how early in the 30-year cycle it goes ahead. The dynamic here is that it is virtually a lock that sometime within a 30-year period valuations are going to become a big factor. And one big win due to valuations makes a huge difference at the end of 30 years after compounding is taken into effect. The numbers are counter-intuitive (as is always the case with compounding) and very impressive.

I STRONGLY agree with your point that there is more than one possible VII approach. This one is a little bit of a pet peeve of mine. People often ask me “What is the best allocation at today’s P/E10 level?” There is no one answer. Asking that question is like asking John Bogle “What is the one stock allocation that everyone should go with?” VII is different than Buy-and-Hold in that it posits that an investor must not go with the same allocation at all times. But it does not posit that
valuations are the only factor. So the investor still needs to take his financial goals, his age, and his risk tolerance into consideration.

RobCast #137 is titled “Nine VII Portfolio Allocation Strategies”:

http://www.passionsaving.com/personal-finance-podcasts-page-eighteen.html

Sorry to dump even more material on you. Please just look at what you think might be of use when you get a chance to do so. You will learn that expressing even limited interest in any of this stuff when I am in the room can be dangerous!

Rob

Wade Pfau: “I Like Your Term ‘Historical Surviving Withdrawal Rate’ As a More Accurate Description of What Traditional Studies Like Trinity Show”

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Yesterday’s blog entry set forth the text of an e-mail that I sent to academic researcher Wade Pfau on December 18, 2010. Wade responded later the same day.

He said that he agreed with my comment re the Business Week article that safe withdrawal rates can rise a good bit higher than 4 percent as well as drop a good bit below 4 percent. However, he argued that the SWR was likely to remain low for some time and thus maintained that “perhaps it is not a major oversight on the author’s part.”

Wade noted that I had moved from my work on SWRS to examining the effect of valuations on allocations and expected returns and said that he expected to do research in that area within the next year. He observed that “I do like your term ‘Historical Surviving Withdrawal Rate’ as a more accurate description of what traditional studies like Trinity show.” He noted that he remembered me using that term in my posts at the Vanguard Diehards board.

Finally, Wade observed that the thread he started on safe withdrawal rates generated far fewer posts than threads he started on two earlier research papers. “It’s interesting to see the difference,” he said.

The text of my response e-mail follows:

Wade:

Yes, all that is so. The initial SWR discussions were strange in that some reacted with great excitement and some with a great determination to shut down the discussions. My focus then turned to figuring out what was behind that. And that led to all sorts of explorations of all sorts of valuations-related topics.

I ultimately concluded that the confusion stems from the fact that Fama’s model (the Efficient Market Theory) starts from premises that are the opposite of those in Shiller’s model (Valuation-Informed Indexing — the title is mine but the core ideas are Shiller’s). I write a weekly column called “Valuation-Informed Indexing” at the ValueWalk.com site that aims to point out all the differences between the old model and the new model. The column is aimed at better-informed investors
(the type of people who practice Value Investing tend to be well informed, in my assessment) rather than at the typical middle-class investors to whom I direct most of my writings. I first wrote eight articles describing each of the four calculators that John and I developed together, and then added so far 20 weekly columns. Here is a link to the archives:

http://www.valuewalk.com/category/valuation-informed-indexing/

If I were going to pick out one column entry to illustrate the basic idea being explored, I think it would be this one (“Either Valuations Matter Not at All or They Matter A Great Deal Indeed”):

http://www.valuewalk.com/asset-allocation/ivaluationinformed-indexingibr-valuations-matter-matter-great-deal/

The best comment that has been made on my work was a comment by Columbia University Economist Rajiv Sethi, who said: “Rob Bennett makes the claim that market timing based on aggregate P/E ratios can be a far more effective strategy
than passive investing over long horizons (ten years or more). I am not in a position to evaluate this empirically but it is consistent with Shiller’s analysis and I can see how it could be true.”

That statement hits it on the head. It would be dogmatic for me to say that everyone must agree with me. I do NOT say that. What I say is that pretty much everything I say follows from what Shiller says in his book “Irrational Exuberance.” The subtitle of the book is: “The National Bestseller that REVOLUTIONIZED the Way We Think About the Market.” Shiller is making a declaration that he REJECTS the conventional model (the Efficient Market Theory, or Buy-and-Hold).

People have been trying to have it both ways now for 30 years. They advocate Buy-and-Hold and they also say that valuations matter. If valuations matter, Buy-and-Hold is dangerous. If the market is efficient, valuations don’t matter and Buy-and-Hold is the ideal strategy. It’s an either-or. I don’t mind people saying that they reject Shiller and thus they reject all that I say. That makes logical sense. But, if Shiller is right, there are all sorts of implications that follow from his revolutionary work. The strange thing is that, while Shiller’s work is well regarded, neither Shiller not anyone else has explored the strategic implications of his findings. Doing that has become my Life Project for the past eight years.

I’d like to illustrate how someone following the VII model would respond to your finding that the predicted withdrawal rate in 2008 was 1.48 percent. Drip Guy obviously saw this as a BAD thing, almost a catastrophically bad thing. The Valuation-Informed Indexer does not see it that way. It is just a data point that provides guidance on how best to invest. A low SWR is neither a good thing nor a bad thing. It is a neutral reality.

In 2000, the SWR for TIPS was 5.8 percent. That is an amazing SWR for a risk-free asset class. All that retirees had to do was to move their money into TIPS and they could retire with great safety. The problem is that this option was rarely recommended because under the Buy-and-Hold Model it is a logical impossibility. Buy-and-Hold posits that the higher returns associated with stocks are the result of the greater risk associated with stocks. So a risk-free asset class can never be expected to provide higher long-term returns than stocks. VII rejects this way of thinking about things. So Valuation-Informed Indexers are free to consider asset classes offering far better value propositions than stocks and thereby to solve the problem presented when the SWR for stocks is very low.

The SWR for TIPS is obviously lower today. But an argument can be made that TIPS offer an even better deal today than they did in 2000. Why? Because the P/E10 for stocks is on its way to 7 or 8 (we have gone to 7 or 8 in the wake of every trip to 25 or above — bull markets always cause enough economic destruction to bring valuations to half of fair value). When the P/E10 for stocks is 7 or 8, the most likely annualized 10-year return for stocks is 15 percent real. So money put in TIPS today will not earn only the amount provided directly through ownership of TIPS. It will earn that amount for a few years and then it will earn the far higher return available for stocks selling at a P/E10 of 7 or 8. The long-term return on that money will be a combination of the amounts earned on the TIPS and the amounts earned on the stocks once the stocks are priced well. Again, the low SWR for stocks today presents no problem. That is a temporary reality than can easily be avoided by moving assets to asset classes offering a more appealing long-term value proposition.

You say that it’s not too big a deal that the article doesn’t mention that the SWR will someday go up much higher than 4 percent. I of course  am glad to see any article that points out that the SWR is sometimes a good bit lower than 4 percent. But I also think that the strategic point is a very important one. VII is a LONG-TERM investment strategy. All strategies are based on the idea that investors need to plan ahead. It is also an emotionally BALANCED strategy. It treats all price changes as having both positive and negative aspects. The same thing that causes low SWRs (high valuations) also causes crashes, which cause low valuations, which cause high SWRs. There is no such thing as a permanently low SWR. People don’t need to be concerned about low SWRs so long as they know how to respond strategically to take advantage of them in the long run.

The problem is that Buy-and-Hold does not permit consideration of the idea that super-safe asset classes can offer long-term returns far higher than those available from stocks. So long as an investor is working from that premise, all attractive options are closed to him at times of high valuations. Once we give up a belief in the EMT and in the Buy-and-Hold Model that follows from it, hundreds of doors open to us. My aim is to describe those opportunities to people.

Sorry for all the words. I hope that there is at least some useful stuff to be found in them. Please don’t feel any need to respond while you are away from the usual grind. If you have any questions or concerns or comments or added thoughts, I’d be thrilled to hear them at any time it is convenient for you to share them.

Rob

Rob Bennett to Wade Pfau: “It is 100 Percent Wrong That People Posting at Bogleheads Feel Intimdated re Posting My Name…. By Using My Name, You Help Others Get Over Their Feelings of Intimidation”

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Yesterday’s blog entry described two emails that researcher Wade Pfau sent me on December 18, 2010. It also set forth the text of my response to the first of those e-mails. The text of my response to the second of those e-mails is set forth below.

Wade:

Thanks for putting an apology in the new post. That’s fine. I think it is especially good that you mention my name in the new post. It is 100 percent wrong that people posting at that board feel intimidated re posting my name. It obviously is not only you who have felt that intimidation. Lots of good and smart people have felt it and the discussions there obviously would be much more productive if people did not feel that. By using my name, you help others to get over their feelings of intimidation.

Drip Guy is a Super-Goon. I am not saying that you should not respond to him. The points he made in his post needed to be addressed. I am just pointing out that he has a long history of posting with bad intent on numerous boards. It would be wonderful if you got somewhere with him but I don’t see the odds as being good.

The point that matters most from my perspective is where Drip Guy says: “That is, if you had chosen to blindly withdraw 4% per year from a nest egg, it would have lasted at least 30 years until depletion, with 95% conf.” It is this way of saying things that is the cause of most of the confusion, in my assessment. It is of course an objective historical fact that 4 percent always worked in the past. 4 percent is the Historical SURVIVING Withdrawal Rate. There is certainly no question in my mind re that.

What I do not get at all is how he can say that a 4 percent withdrawal could be taken “with 95% conf.” Looking back, we know that 4 percent worked. So, looking back, you could take 4 percent with 100 percent confidence. But a determination of what is safe is by definition a forward-looking concept. The entire idea of having confidence in something only makes sense if you do not know what is going to happen. So the confidence percentage must take into consideration the factors that were unknown to the retiree at the time be began his retirement.

We know the range of possible returns starting from any possible valuation level. What we do not know is what particular returns sequence is going to pop up. Say that the retirement began in 1929. In 1929, 50 percent of the returns sequences that we have seen in the historical record permitted a 4 percent withdrawal to work and the other 50 percent caused a 4 percent withdrawal to fail. So it seems to me that the confidence level for a retiree taking 4 percent for a retirement beginning in 1929 is 50 percent, not 95 percent.

Yes, that retirement worked. But not because it was safe. A retirement that has only a 50 percent chance of working out cannot be retroactively characterized as “safe.” It was a risky retirement plan that worked because of good luck (a good return sequence happened to pop up). I am not able to think of any other field of human endeavor in which we determine what is “safe” by seeing what worked in two or three tests.

Say that we wanted to find out whether drunk driving is safe or not. We test 100 drivers driving 20 miles. 98 of the drivers are sober. 2 are drunk. The 98 drive the 20 miles without incident. The 2 get in major accidents and live but are crippled for life. Would we conclude from this that driving drunk is “safe”?

That’s what we are doing with the Old School SWR studies. A 4 percent withdrawal usually works with lots of room to spare. But it always means trouble for retirements that begin at times of high valuations. Prior to the 1990s, there were
only two times of super-high valuations in the modern record. On both of those occasions, 4 percent barely worked (although it worked with lots of room to spare on all occasions when valuations were not super-high). No, the 4 percent withdrawal did not bring death in either of the two tests (that is, the portfolios did not go to zero). But it came awful close in both cases. Is this not telling us that 4 percent is a high-risk withdrawal rate for retirements beginning at times of super-high valuations?

It seems to me that the Old School SWR methodology is telling us the Historical Surviving Withdrawal Rate. That’s a very different concept than the SAFE withdrawal rate. To determine what is safe, we need to look at the factors that determine what is safe. The record shows that the single most important factor is the valuation level that applies on the day the retirement begins and yet the Old School studies contain no valuations adjustment whatsoever. How could they possibly tell us what is safe if they do not even look to the factors that determine what is safe? This is why I say that these studies are “analytically invalid.”

Rob