A Rich Life

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

“This Is All Upside and Zero Downside”

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I recently posted a Letter to the Editor at John Walter Russell’s site that points out the absurdity that there are people who view it as “controversial” to take into account the reality that valuations affect long-term returns when developing investing strategies. It is entitled Re “A High Stock Allocation for Today.”

Juicy Excerpt: It might be so that there aren’t many things one can do in life that offer a free lunch. But taking valuations into account is surely one of them. This is all upside and zero downside. And yet it is controversial as can be. Yikes!

Should You Resist Hunches Or Yield to Them?

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Neither.

You should explore them. You should try to figure out where they are coming from, what they mean.

Hunches are not the product of logic. In that sense they are irrational.

But some hunches represent a sort of super-logic. There are circumstances in which a hunch can permit you to jump over the limits of pseudo-logic to something better and more financially rewarding, a healthy, emotionally balanced logic.

At the root of the paradox is the human capacity for self-deception. Logic alone can never get us to where we want to go for so long as we are so prone to tell lies to ourselves. Lie-inspired logic can take you over a cliff by insisting that you continuine to move in a straight line no matter what your eyes tells you about the dangers just up ahead. There are cases in which a hunch can serve as a veto over the mad logic that if not questioned could ruin you.

Say that you’ve bought into the Passive Investing idea. It’s worked well for a good number of years. The logic says that you must never change your stock allocation no matter how wrong it comes to feel not to do so. Yet a hunch tells you that the Passive Investing idea was yesterday’s hot investing strategy, that the smart money is moving to a new understanding of what it means to “Stay the Course.”

Listen to that hunch!

In all seriousness, that’s a good hunch. That’s just common sense. The idea that you should stick with a stock allocation chosen at a time of reasonable prices when prices have gone to la-la land is obviously the product of a wild bull-market psychology. When the bull market goes bye-bye, so should the bull-market “logic.”

The problem is that you’ve adopted an irrational idea as the core principle of your investing mindset. You’ve left no means for common sense to persuade you through ordinary channels. So it takes a different route. In this case, common sense appears to you in the form of a hunch. It dresses up in irrational clothing to bring a rational message to a guy or gal who tried to abandon rationality for good but who is a bit too smart to stick with the program once the emotional pull toward doing so has disappeared. That hunch is the better part of you, the smart side of you. Let that good-looking fellow in the door! Give that clever gal a hand with her coat!

Not all hunches are like that, unfortunately. Hunches have a bad reputation in the investing realm because hunches cause a lot of trouble in the investing realm. You don’t want to let just any good-looking fellow in the door. You don’t want to be jumping up to help just any clever gal with her coat. You need to be discriminating.

You lower your stock allocation to bring it to where it should be at a time of sky-high prices. And prices really do come down. You feel like a genius. You feel like so much of a genius for anticipating the price drop that you begin to feel uncomfortable with even the small stock allocation you are now going with. The newspapers are now saying that stocks are for losers. They sure changed their tune! Maybe you should sell it all? Selling worked for you before. There must be a reason why the newspapers, which have in your experience always been biased in favor of stocks, are now urging you to dump them.

No, no, no. no, no.

In this case the hunch represents not common sense, but common fear. The newspapers are consistent enough. They are consistently emotional, consistently irrational. They reflect our own irrationality back at us. We should pay about as much attention to the newspapers when they are pushing us to get out of stocks for emotional reasons as we do when they are pushing us to stay overinvested in stocks for irrational reasons.

This is a hunch that comes from a bad place. This is a hunch that I would try hard not to listen to.

Some hunches are good. Some hunches are bad. How the heck are we supposed to know the difference?

Lift your hunch up in your hands and examine it. Study it. Check its history — where did it come from? Hold it up next to your other investing beliefs. Does it fit in? If it doesn’t fit in, is it because your other investing beliefs don’t get out enough, that you have become too insular, too dogmatic?

There is no one rule on investing hunches. Hunches can be of great positive value or of great negative value. I can say that you do not want to ignore hunches. Even the ones that you do not want to listen to can make you aware of weaknesses in your understanding of how stock investing works (if you were confident in your beliefs, bad hunches would not trouble you). So don’t be dismissive of hunches. Try to gain a sense of why you are experiencing them.

The person who says that he or she never experiences a hunch is like the person who says that he or she never gets annoyed with his or her spouse. I mean, come on. Hunches are a sign that you do not know it all. And you don’t. So it is not necessarily a bad thing to see this sign of the obvious reality appearing before you.

Don’t kick your hunches out as if they were unworthy, irrational things. And don’t embrace them casually. The appearance of a hunch is a sign that you have not thought things through carefully enough. It’s better to have a hunch getting you back to work than to experience a poor investment result.

Don’t automatically resist hunches and don’t automatically yield to hunches. View them as an reminder of the need to continue looking at things from different angles, to continue learning. Hunches are frightening only to the overly dogmatic.

Today’s Passion: I have a funny feeling that we will talk more about hunches as we continue boldly into The Future of Behavioral Finance.

Safe Investments Can Offer Higher Returns

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Those six words sum it all up. That claim is what The Great Safe Withdrawal Rate Debate has been all about.

The dominant investing theory of today — the Efficient Market Theory — says that it cannot be so. This theory posits that investing is a 100 percent rational endeavor. It makes no sense for safe investments to offer higher returns than risky investments. It is irrational. It cannot be. So says today’s dominant theory, a theory that has influenced 90 percent of what you have read about what to do with your savings for the past 25 years.

The Efficient Market Theory says that it cannot be so. What does The Stock-Return Predictor (a calculator that reports how stocks will perform in the future presuming that they perform in the future anything at all as they have always performed in the past) say? The Return Predictor tells us that at the top of the bubble (the P/E10 level was 44 in early 2000) the most likely 10-year annualized return for stocks was a negative 1 percent real. TIPS were at the time paying 4 percent real with a government guarantee attached. The safest investment in the world was paying five full percentage points more of return per year than stocks, which were at the time the riskiest an investment they have even been in U.S. history.

Safe investments can offer higher returns. That’s the reality.

The reality conflicts with the theory. What to do, what to do?

The “experts” say that we need to ditch reality, cover it up. Telling people the realities might undermine their confidence in the theory we all use to tell people what to do with their money.

Huh? Whazat?

Reality trumps theory. If the theory conflicts with reality, it is the theory that is wrong — the purpose of a theory is to describe reality accurately. We don’t dump reality. We dump the theory. So says Old Farmer Hocus.

Safe investments can offer higher returns. You would think judging by the reaction we have seen that telling people that is telling them bad news. It’s not, of course. It’s wonderful news. What could be better than learning that you can get higher returns by taking on less risk? That’s what we all should be seeking to do.

To get angry upon learning how to do it is to become a slave to theory, to put the desire to hang on to a discredited theory ahead of the desire to finance our retirements. Not this boy. No way, no how. I’m here to learn how to achieve financial freedom as early in life as possible. I love theories that help, I have no use for theories that hold me back.

Safe investments can offer higher returns. They usually do not, of course. The usual rule is that safe investments offer lower returns. But there are times when things are stood on their heads. How come? How do things get so messed-up? Why isn’t stock investing rational, as the theory insists it must be?

It’s because stocks are bought and sold by humans and humans ain’t rational. Perhaps you’ve noticed.

Take the humans out of the equation and perhaps we can bring that Efficient Market Theory back for another run. For so long as humans are permitted to own stocks, though, forget it. Assuming rationality in those circumstances is going off to live in an imaginary world. That’s not the smartest thing to do when putting together an investing strategy.

Here’s the kicker.

It’s only by acknowledging that human investors are irrational that humans can invest rationally. Holy irony, Batman!

There’s a fellow named Larry Swedroe (he’s written some investing books) who I mentioned this to over on the Vanguard Diehards board. His response was that, when stocks pay a lower return than normal, they are safer than normal. Stocks were paying the lowest expected return in history back in 2000, so it follows under Swedroe logic that stocks were the safest they have even been in those days. What do you say to something like that?

I said that it sounded to me that he was repeating back to us stuff he had read in books rather than using his intelligence (it is clear that Larry possesses a good bit of intelligence) to come to a rational understanding of the realities. He said that I was being “patronizing.” Again, what do you say?

Was I being patronizing? I feel that I was showing more respect for Larry’s intelligence than Larry himself was showing for Larry’s intelligence. Larry was putting forward words that made Larry sound like a fool. I know that Larry is not a fool. I was trying to lift Larry’s thought process to a higher place.

Safe investments can offer higher returns.

If you can accept that, you can learn how to invest rationally. Figure out why it is that safe investments sometimes offer higher returns than risky investments and you are well on your way to figuring out how stock investing works in the real world.

The alternative is to become a slave to a theory that has failed us.

I like theory as much as the next guy, probably more. But I only like theories that work. When I see that a theory does not explain reality at all well, I go off looking for another theory.

How about you?

Today’s Passion: One weekend I went to visit my mother in Philadelphia and didn’t bring my computer with me. I woke up early and was looking for something to do. So I pulled out my notebook and tried to come up with some reasons for sticking with a theory after it becomes obvious that it has failed. The work product of that morning’s effort is an article entitled Woody’s Allan’s Take on the Efficient Market Theory. The short version is that we believe that safe investments cannot offer higher returns because, well — we need the eggs.

Getting Excited About Low Returns

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Community members have told me that they find it “depressing” to invest in TIPS, IBonds or CDs at a time when the returns paid on them are as low as those that apply today. I don’t think you should find today’s low returns depressing. I think you should find them exciting. The low returns that apply today for the super-safe asset classes are a sign that the investor psychology that has kept stock prices high for so long is in the process of breaking down. That’s very good news indeed for the Valuation-Informed Indexer.

Would you prefer the returns that applied at the top of the bubble, when TIPS were paying in excess of 4 percent real? I of course understand that in a direct sense that’s a far more appealing return than what is available today. I am not so sure that those buying TIPS today are not getting the better deal, however. I think it is entirely possible that that is so.

To understand why, you need to think a bit about why an asset class as safe as TIPS was paying so high a return back in early 2000. One big reason is — the enthusiasm for stocks was off the charts at the time. Stocks offered a terrible long-term value proposition at the time; the likely 10-year return was a negative number. But it was even harder to find “experts” talking straight about how stocks work then than it is today. The value proposition was awful. But stocks have never been more attractive to middle-class investors than they were in those days when the likely 10-year return was a negative number.

What do you think the insane demand for stocks did for the return offered to those buying TIPS? It pushed it up to arguably equally insane levels. In a rational world, a risk-free asset class should never offer a return of 4 percent real. But in the world we actually live in, the demand for stocks was so great back at the top of the bubble that there was no way to get investors interested in TIPS without offering insane rates of return for those willing to buy them. The value proposition for TIPS was outstanding in 2000 because the emotional appeal of stocks was so out-of-control strong.

The super-safe asset classes have outperformed stocks for over eight years now. Investors have noticed. So the price of stocks has dropped. Not to levels anywhere close to reasonable. But prices have dropped considerably. And the interest in alternatives to stocks has grown.

What do you think that has done to the returns offered by the super-safe asset classes? It has pulled them down. You cannot get much of a positive return at all today from TIPS, IBonds and CDs. The days of 4 percent real returns are over.

That’s not depressing news.

I think a good argument can be made that it is exciting news indeed.

I put lots of money into TIPS and IBonds back when they were paying 3.5 percent real. I didn’t do it because I like the idea of earning 3.5 percent real on my investments. I did it because I like the idea of earning a whole big bunch more than that and because I know that owning stocks is the way to earn a whole big bunch more than that and because I know that I will be able to own a whole big bunch more stocks if I buy stocks when they are selling at reasonable prices.

For stock prices to drop, we need to see millions of investors become sick of the low returns stocks have been paying for a long time now. The drop in the returns paid on the super-safe asset classes is a sign that investors are beginning to get that sick feeling. Do you see where I am going with this?

In a surface sense, it is obviously better to earn 4 percent real than to earn 0 percent real or something close to it. But there’s not much money to be made hiding out in TIPS and IBonds and CDs. My super-safe portfolio has been beating the S&P index for over 10 years now. But all things considered, I’d rather be in Philadelphia. Nothing would please me more than to be able to ditch these wonderful TIPS and IBonds paying 3.5 percent real and put the money into stocks paying a likely return of at least double that.

The idea isn’t to beat the S&P index. The idea is to get rich. As TIPS/IBond/CD returns drop, the crazy emotions holding up stock prices get weaker and weaker. We get closer and closer to the day when stocks will be offering a compelling long-term value proposition once again. That’s where we want to be, is it not? The purpose of this game is not to hold TIPS paying an attractive return. It is to own stocks paying an attractive return.

The investor who buys TIPS paying a real return of zero and who is able to move his money into stocks within a year or two or three is better off than the investor who buys TIPS paying a real return of 4 percent and who is not able to move his money into stocks for nine or ten or eleven years. Those who are depressed about the low returns being offered by the super-safe asset classes today are failing to note the extraordinary opportunity opened to them by buying those “low-return” asset classes, in my estimation.

Your true long-term return is not the return you earn by being invested in super-safe asset classes. It is the return you earn by being invested in super-safe asset classes for a time and in stocks purchased at reasonable prices for a longer time. If the day at which stocks will again be available at reasonable prices is drawing nearer, we all are better off. Having to accept low returns on the super-safe asset classes is a small price to pay for having reasonably priced stocks available to us again soon.

It could be that I am wrong about this. The historical data does not permit statistically significant short-term stock-price predictions. It could be that stock prices will remain high for another eight years and that the low rates available today on the super-safe asset classes will end up hurting you big time.

That said, it seems reasonable to me to interpret the big drop in returns paid on the super-safe asset classes as a sign that the insane emotionalism over stocks is beginning to break. For those following rational investing strategies, things appear to be looking up.

Today’s Passion: Stocks are my favorite asset class, for the reasons noted above. But I didn’t let that stop me from writing an article entitled Cash Is King — I’ll Prove It With Numbers.

This Month’s Permanent Portfolio

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The great thing about studying what investors say on discussion boards is that you learn about how things work in practice, not theory.

Investors have been told for 25 years now to follow buy-and-hold strategies. And they say they do. But do they really?

I’ve seen hundreds of comments indicating otherwise. One thing I’ve seen a lot of is a rigid adherence to the idea of buy-and-hold combined with an extremely loose understanding of what it involves in practice.

There are lots of investors out there who in 1999 believed with their entire minds, hearts and souls that owning the S&P500 and the NASDAQ forever was the essence of buy-and-hold. Then the idea became to own just the S&P500 forever. Then it was the S&P and value stocks. Then the S&P and REITS. Then the S&P and small caps. Then the S&P and a global index. Then the S&P and Emerging Markets. The idea seems to be growing of late that maybe it’s best to leave out the S&P altogether and just go with all the other possible slices and dices.

That ain’t buy-and-hold. The idea of buy-and-hold was to stick with a plan long enough to see if it can really pay off. Switching to a different Permanent Portfolio every six months or so doesn’t do the trick.

Investors are kidding themselves. They like the buy-and-hold idea, and for good reason. It is indeed important to stick with a plan long enough to give it a fair test. But the promoters of the buy-and-hold concept did a poor job of pointing out the pressures that those following it will feel to abandon it. As a result, most would-be buy-and-hold investors are unprepared for those pressures and have no idea how to respond to them other than to change their understanding of what constitutes buy-and-hold regularly enough to keep up with their changing desires to own different classes of stocks.

Buy-and-hold is a good idea. But the popular formulation of it is unrealistic. We need a new understanding of how buy-and-hold can work, one that stands a better chance of playing out well in the world of flesh-and-blood investors.

The problem is that buy-and-hold became popular during the longest and strongest bull market in U.S. history. People came to think that you could buy the S&P and forget about it. That of course can never work. When the S&P is selling at reasonable prices, it is a wonderful asset choice. When it is selling at the sorts of prices that apply today, it represents a dubious long-term value proposition.

If we could just say that, we could develop all sorts of strategies for following what are basically buy-and-hold strategies but that are a good bit less rigid than what many of the promoters of the concept have endorsed. Until we develop that freedom, many investors will feel that their hands are tied. It is taboo to change one’s stock allocation or one’s mix of asset classes. But it’s becoming increasingly clear that it is foolhardy not to make some changes in one’s portfolio when the investing environment changes dramatically.

Is it okay to make shifts in the makeup of your portfolio from time to time? Of course. It’s not only okay, it’s pretty much mandatory. None of us knows it all starting out. We learn over time. If we didn’t put what we learned into effect by changing the makeup of our portfolios, there wouldn’t be much point to learning, would there?

We need to be more up front about the changes we make and the reasons why we make them. Many investors have given up on the S&P500 in recent years. For good reason. The S&P is dangerously overvalued. We should learn from our mistaken belief of yesteryear that the S&P would always be as attractive a buy as it was back in the time when it was available at a far more reasonable price.

Buy-and-hold should be a tendency, a goal, a principle. When we make it a dogma, we switch onto the wrong track. We all need to make changes in our portfolio composition and in our stock allocation from time to time. We should discuss those changes openly and thereby learn lessons from the mistakes we made at earlier times.

Today’s Passion: The article entitled Basics of the New Buy-and-Hold provides a groundwork for the development of a new way of implementing this strategy.

Conventional Method of Calculating P/E10 Questioned

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Brad DeLong has questioned the conventional approach to calculating P/E10.

Juicy Excerpt: This is not quite right. This gives you permanent earnings five years ago. To get permanent earnings today you have to grow the average by five years of the trend growth rate of real earnings–which has been 6% per year over the past twenty years. The current value of 28 for the price-to-moving-average-of-lagged-earnings ratio corresponds to a price-to-permanent-earnings ratio today of roughly 21, and to a current r of 4.8% per year.

A community member brought this to John Walter Russell’s attention in a recent Letter to the Editor posted to his site.

Juicy Excerpt: He is trying to tie the numbers down to absolutes, to what would be the “right” price to pay for stocks in a theoretical sense. His research is valuable.

John followed up by writing an article entitled Weighted Earnings.

Juicy Excerpt: The 1.06 weight treats all years equally in terms of the long-term trend line. It estimates the Investment Return of the stock market. The 0.94 weight greatly emphasizes recent earnings. It reveals the Speculative Return.

The technical material is over my head. I am pleased to see this sort of discussion going on. I am strongly convinced that using P/E10 is a major advance over using P/E1, the greatly flawed conventional stock-valuation metric. But I do not believe that we are anywhere close to having reached the end of our explorations of the effect of valuations on long-term returns.

We are in the early innings of this ballgame. We need to see many more investing experts and many more ordinary investors making constuctive contributions to the discussions. No small group of people is going to figure all of this out in a definitive way. Projects of this scope and importance require the input of people coming from a variety of backgrounds and perspectives.

The more that I see these sorts of questions discussed, the better I feel about the long-term future of middle-class investing. Rob Arnott has said that we are now in the early stages of a “revolution” in our understanding of what works in stock investing. I think that’s right, and I think that the question of what valuation metrics do the best job is a question that will be brought front and center as that revolution comes to affect the financial furtures of us all in profound ways.

Today’s Passion: Robert Shiller relied on P/E10 to make his famous stock-market prediction of 1996. Did he turn out to have been mostly right or mostly wrong? That question is examined in the article entitled The Famous Robert Shiller Stock-Market Prediction.