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Academic Researcher Wade Pfau: “I Would Not Be Surprised If the Market Timer Had to Go All the Way to 200/0 to Get a Strategy With the Same Risk as 100 Percent Stocks”

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Yesterday’s blog entry reported on two e-mails that I sent to Academic Researcher Wade Pfau on March 1, 2011. Wade sent his response the same day.

He said: “I think having that debate with Mel helped me to clarify some stuff in my mind, which I can more or less copy and paste into my paper after making some adjustments so that it sounds more “academic.”

In response to my suggestion that he consider looking at hypothetical portfolios that employed stock allocations of greater than 100 percent at times of low valuations, he said that this would not be difficult to do and that he would plan to do it in a future paper but not in the one he was preparing at the time. Wade told me that, based on the analysis of the historical data that he had been doing, “I would not be surprised if the market timer had to go all the way to 200/0 to get a strategy  with the same risk as 100% stocks.”

He added that: “The fact that you should only compare risk-adjusted returns is very basic in finance.  Academically, it is clear in Markowitz’s work from the 1950s.  But no one was acknowledging that they agree about this.”

I sent my response the next day. The text is set forth below.

Wade:

In the main paper, will you be able to use some of the tools you referred to in the Bogleheads post? I am referring to the risk-oriented ones (for example, the one that said the highest drop experienced for 100 percent stocks was x and the highest
drop experienced for 100/0 stocks was y)?

If you are able to do that, it would make me very happy. The discussion over whether that matters or not goes back to the very first day — May 13, 2002. I have been saying that VII must bring better numbers (I said this long before anyone knew what the numbers were — I’ve never viewed the numbers as being anything more than CONFIRMATION of what common sense tells us must be so) but I also have made a totally separate argument — that the numbers shown for VII are realistic while the numbers shown for Buy/Hold are not  because there are probably only a tiny number of investors in history who have stuck to Buy/Hold through an entire Bull/Bear cycle (at the moment of biggest loss from 1929 forward, the real loss was 80 percent real — it’s a rare individual who could stick with a high stock allocation through that).

John Walter Russell provided huge help in showing that the numbers for VII are better than for Buy/Hold (although I think your rolling 30-year period showing is more compelling). But I was either never able to explain the other point successfully to John or he was not familiar enough with the tools needed to make the point effectively (he was a systems engineer). He tried a few things but our efforts on this second point never produced much usable material. My focus has always been on the emotions side rather than the numbers side. So in my mind this is actually the bigger point (I have generally given up putting it forward largely because I have not been able to find statistical support for it and in this field that often seems to be the only sort of evidence that “counts”).

I would love to see more support for that point (I am certainly not trying to push here, I am just saying that I would be grateful to see it if there comes a day when it is something that can be provided).

There was an amazing conversation I once had with John Greaney, the Supreme Leader of the Goons, back at the Motley Fool board. The largest real loss in the record is 80 percent. John retired at age 41 and used his Old School SWR study to plan his early retirement. He retired with about $500,000 (that went to about $3 million during the bull years). I asked him what he would have done if, in the first three years of his retirement, the value of his portfolio had fallen to something not much above $100,000 (he goes with a 90 percent stock allocation). He said that he would have just stick with his 90 percent stock allocation because his SWR study proves that his plan cannot fail (that stocks would turn around and he would make all the money back plus a lot more).

My response (this was early 2003) was: “I’m going to take a brief Screaming Break now, everyone. I’ll be back in a little while.” I am certain that there were others in the room who agreed with me. But no one else dared to speak up.

Rob

Academic Researcher Wade Pfau in Response to Mel Lindauer’s Claim That His Research Engages in Data-Mining: “I Take the Issue of Data-Mining Very Seriously, and, With All Due Respect, Any Data-Mining That I Am Doing Is In Favor of Buy-and-Hold, Not In Favor of Market Timing”

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Yesterday’s blog entry reported on an e-mail that I sent to Academic Researcher Wade Pfau on February 25, 2011. Set forth below is the text of another e-mail that I sent to Wade on the same day.

Wade:

Please save this for after you catch up on your sleep!

You’re right about the regret bias.

But it won’t be a problem once we are able to get the word out re the need for long-term timing. Say that Money magazine and all the experts and all the web sites all begin pushing that message. There will never again be another bull market. So there will never again be a need to lower one’s stock allocation too much. So there will never again be regret bias.

All of this is circular. People cannot learn about VII because of the Ban on Honest Posting. The Ban is needed to protect Buy-and-Hold. If we give up on the effort to protect Buy-and-Hold, we learn things that it was not possible to
learn in the days before indexing. Once we learn these things, we are never going to forget them. There are going to be books and magazines and calculators and web sites to constantly remind us.

Overvaluation is not a natural phenomenon. It is the product of our ignorance of how stock investing works. We are becoming less ignorant because of decades of academic research (including the research done by the Buy-and-Holders, to be sure — the finding that short-term timing does not work was a HUGE advance).

When the car was invented, one of the complaints was that there were not enough roads to ride it on. Once we all had cars, we solved that problem! When the internet was invented, people said “well, there’s not much there to look at really.” Once we all had computers, we solved that problem.

Once we all know how to invest effectively, no one is going to want to go back to experiencing insane bull markets followed by insane bear markets. For what purpose would anyone want to do that? Those days are over. It’s just a question of getting the word out at this point.

Future discussions will not be over whether to engage in market timing or not but over how best to engage in market timing. There are lots of fruitful discussions that can be held re that question. That’s a very different sort of discussion from the one we have been having for nine years. When we are all directing our energies in a constructive direction, the pace of progress is going to speed up considerably.

The question of whether people need to engage in market timing or not (whether people need to take price into consideration when buying stocks or not) is a time waster. The future of investing analysis will be aimed at answering a far more intelligent question — HOW should people engage in market timing?

As we move to the next stage, the investor regret matter becomes less of a factor. It’s helpful to keep in mind that we have just lived through the most out-of-control bull in U.S. history. Why was this one so bad? Investors have always been drawn to Get Rich Quick thinking (the idea that this might be the first time in history when the price paid for stocks turns out not to matter). But this time those drawn to Get Rich Quick could cite ACADEMIC STUDIES purporting to back up their Get Rich Quick inclinations. That’s why I say that Buy-and-Hold is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind (not intentionally so — but still).

Once we bury Buy-and-Hold 30 feet in the ground where it can do no further harm to humans and other living things, it is all downhill sledding. The investor regret matter was indeed a problem for those who attempted to invest rationally during the Buy-and-Hold Era. But it never needs to be an issue again once the dangers of Buy-and-Hold become widespread public knowledge.

Rob

Wade responded later the same day. He said: “I think you will find my new follow-up post even better than the first one”:

http://www.bogleheads.org/forum/viewtopic.php?p=974752#974752

In the material that appears at the link, Mel Lindauer, the co-author of the book The Bogleheads Guide to Investing, attacked Wade’s research for various perceived deficiencies. Wade responded: “Mel, thank you for the comment. If you think I am trying to be sneaky, I think you are missing something important.” When Mel escalated his attacks by observing “sure looks like data-mining to me,”  Wade stated: “I take the issue of data mining very seriously, and with all due respect, any data mining that I am doing is in favor of buy-and-hold, not in favor of market timing. ”

Mel in a subsequent comment said: ” I’m just trying to get to the bottom of all the issues, before you attempt to publish what may be found to be inferior or incomplete work by your peer reviewers. You appear to honestly want to pick our brains, so I’m giving you the feedback you asked for. These are issues that will be raised later, so you need to face them now. However, it appears you’re getting just a little bit testy because I’m raising issues that you may not have considered and which could certainly change the results. Better to get the issues raised here and resolved instead of having your paper rejected because of these very basic issues which you haven’t addressed.

Wade responded: “I’ll try not to get testy. When we stop comparing apples and oranges, and instead compare two scenarios which offer broadly similar risks to investors: (1) the worst performing market timing scenario produced $94,866 ; (2) a 50/50 asset allocation produced $13,426; (3) the 50/50 asset allocation is also going to have to pay some capital gains taxes when it rebalances annually, but the market timer will surely have to pay more taxes over time. But do you honestly believe that the extra taxes paid by the market timer will wipe out the entire surplus gains it had provided at a broadly similar level of risk? ”

Mel responded by pretending that he believed that Wade had changed the scenarios he was describing. He said: “The figures in your original chart were 100%/0 and now you’re talking about the returns for a 50/50 portfolio?”
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Wade said: Please refer to my post above that includes a table and a figure. I talk about both cases there. I’m not switching anything. Would you agree that it is not appropriate to compare the returns of different strategies that result from taking very different levels of risk, and that we should compare risk-adjusted returns? In that case, it is 50/50.  Am I the only one who thinks that it isn’t quite right to be comparing a strategy that is 100% stocks against a strategy that is on average only 50% stocks? Fisher and Statman do this, but one of the points I am trying to make is that this isn’t a fair comparison. Am I wrong?”
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Mel said: It’s a very personal thing. Each investor determines the amount of risk they’re willing to take, and many are willing to take on more risk than others for the expected higher returns. Some investors choose 100% equity, some might be 80/20, some 60/40 etc. So you can’t say that all investors should or do wish to assume the same level of risk.
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Wade stated: I’m definitely not saying that all investors should take on the same risk. Of course not.  What I am saying, or asking, is that if you wish to compare two different investment strategies to see which can be expected to provide the highest returns, shouldn’t you make some kind of adjustment for risk? If you ignore risk, then whatever provides the highest expected return over time will tend to win. Is it okay to ignore risk for the comparisons? Or should you only try to compare strategies which offer the same risks? Then, from there, you can move on and make further adjustments to the strategy to calibrate the level of risk you are willing to incur as an individual investor.  To give some context. I am currently 70/30. But I am seriously considering changing to 50% stocks/70% stocks/90% stocks depending on the level of PE10. I won’t do this until at least the summer, because I need to start studying for the CFA Level 3 exam soon, and I can see that it will teach lots of important tools for making these comparisons, and give me more time to think about this rather serious and important decision. I still have 35 or 40 years before I would seriously consider retiring.”
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Mel said: “I’m simply raising issues that others are certain to raise. And ignoring the cost of taxes in the market-timing strategy is a major flaw IMO. ” Do you have clearly-defined and executable buy and sell points where all of the information needed to follow the market-timing system is publicly available to all investors?  Finally, have you considered what the market impact would be if a very large number of investors followed the system and executed their market timing buys and sells on the same day? (I’d guess that there would only be one right buy and sell date for the data to be valid).  PS – Congrats on getting past the first two CFA tests. You’re almost there!”
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Wade responded: “Thank you for these comments. I think we can wrap up our discussion, thank you very much.  Taxes do remain an area I haven’t explored, but would like to. But it will require a lot of work so I cannot do it until after the exam.  About the decision rules with publicly available information, that should not be a problem. After the market closes at the end of the year, people should be able to get an update on PE10 immediately and change their asset allocation for the following year when necessary.  About the potential market impacts of many people adopting this strategy, I don’t have any clear answer. Some may think it will eliminate booms and busts from the market, but as a “dismal scientist” (a nickname for economists) I can’t accept that. There are always unintended consequences to new policies. Bubbles would just form elsewhere. This is an important question though. Under my assumptions, people make their moves on January 1st of each year, but I suppose in reality things wouldn’t work out quite that precisely. But at the end of the day, as well, it will probably be hard to convince a lot of people to overcome the psychological roadblocks of this contrarian investment strategy, so that the market impacts may not be so large.  After all, as you kindly pointed out much earlier, all of this has been around at least since the time of Graham and Dodd.  Thank you again for all your comments and time today.”
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There were no further posts to the thread for twelve days, at which point Wade advanced a post reporting on how the earthquake in Japan affected him and his family. Mel offered his good wishes.

Academic Researcher Wade Pfau: “This Is a Real and Unavoidable Concern. Someone Has to Be Strongly Committed to the [Valuation-Informed Indexing] Strategy to Not Deviate at the Worst Possible Time.”

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Yesterday’s blog entry reported on an e-mail that I sent to Academic Researcher Wade Pfau on February 25, 2011. He sent his response later the same day.

Wade thanked me for my messages, saying that our correspondence “gives me a lot to think about.”

He offered an observation regarding one potential pitfall for those following a Valuation-Informed Indexing strategy. He said: “The worse thing would be if he abandoned the valuations strategy in 1999 to join his friends with 100% stocks.  I
think this is a real and unavoidable concern.  Someone really has to be strongly committed to the strategy to not deviate at the worst possible time.  But I think people can do it if they get a firm understanding about the historical data.”

I sent an e-mail to Wade on that day offering further comments on his exchanges with Drip Guy and other Goon posters. The text is set forth below.

Wade:

You’ll never find consistency in the statements of Drip Guy and the other Goons. Their primary aim is to block fruitful discussions and they will say whatever needs to be said to achieve that aim.

I was FORCED to put up the post of May 13, 2002, that kicked off The Great Safe Withdrawal Rate Debate. Greaney founded the Motley Fool’s Retire Early board. I built the board into the most successful board at the site (posting only about saving). I had to take time off to write my book and a fellow named “Wanderer” became the best poster. Wanderer committed the “crime” of saying that he thought investing in real estate (instead of stocks) could make sense at times. Greaney signaled to his Goons that he wanted Wanderer gone and the deed was done. Greaney’s SWR study was the tool used (if the SWR can never drop below 4 percent, the long-term return for stocks is implicitly always 6.5 percent real and stocks thus can never be beat on a risk-adjusted basis (no need to study anything to invest in a stock index) by other asset classes. If I did not do something at that point, the board could never again serve as a useful place to learn about planning for an early retirement.

By pure coincidence, John Walter Russell had retired the week I put up the first post and was looking for something constructive to do. He did the first New School research on the sixth day of the discussions (May 18, 2002) and found that the sensitivity numbers for the Old School SWR studies were poor. Lots of community members got very excited about learning more.

From that point forward the battle has been over whether honest discussion should be permitted or not. Mel Lindauer (co-author of “The Bogleheads Guide to Investing”) and others knew who I was when I put my first post to the Vanguard Diehards board in July 2005. So my first post was met with abusive posting. Lindauer and others demanded that Morningstar ban me because I was not willing to post dishonestly but Morningstar was not willing to go along given that I had never violated any posting rules. When I announced an intention to appear at one of the annual meetings (where I would be able to direct questions to Bogle), the Lindauer group formed the new Bogleheads board off the premises of Morningstar.com and encouraged people to switch boards. Now the Lindauer/Drip Guy group does not need to get an independent site administrator to impose board bannings and they can maintain the ban without anyone being able to ask embarrassing questions.

You’ll never get anywhere with Drip Guy. I don’t mean to say that he does not follow Buy-and-Hold principles in his own investing. I believe he does. I asked Greaney how much he lost in the crash and he said “well in excess of $1 million.” That persuades me that they personally follow what they preach. But they have zero willingness to entertain the possibility that they have made mistakes. That by itself is not a problem (except for them). The problem is that they also have zero willingness to permit the hundreds of community members there who would like to be able to discuss both sides in civil and reasoned discussions to do so. I see that as a BIG problem in scores of different ways.
There are smart people in the community who say helpful things. But once honest posting is banned the thing becomes a corrupt enterprise.

It might be that Drip Guy and the others would play it a different way if they had a chance to do it over. But they now have to deal not only with having been wrong on SWRs but also with having destroyed numerous boards and blogs in their efforts to block community desires that honest posting be permitted. Drip Guy doesn’t feel even a tiny bit inclined to own up to that, according to every sign I have seen from him. So he often talks incoherent babble. He doesn’t see himself
as having any other choice at this point.

Sorry for the long answer. But I see no other way to help you make sense of the Drip Guy matter and of the fact that a good number of smart community members fail to speak up about it when it becomes an obvious issue.
They know that Drip Guy is in the Lindauer camp. That’s what matters as a practical reality, not whether what he says makes sense or not. And Bogle appears with Lindauer at the annual meetings. Community members there have noted that Bogle allows photos to be taken of him and Lindauer standing next to each other. That sends a signal to people as to what can and cannot be said at the forum.

That’s what needs to change. The entire Campaign of Terror against our board and blog communities comes crumbling down on the day that Bogle appears in a public forum and says the magic words “I” and “Was” and “Wrong” or the somewhat- less-helpful-but-still-magic words “I’m” and “Not” and “Sure.” When those words are said, all of the negative energy converts to positive energy and from that point forward everyone is working together to learn how stock investing works in the real world instead of pursuing counter-productive political agendas. No one gets left behind then. Learning how stock investing works (for the first time — the study of stock investing was
never a systematic academic enterprise before the research was done on the efficient market theory) is a win/win/win/win/win with no possible downside for anyone.

Rob

“Shiller Discovered That the Earth Is Round Instead of Flat and All the Old Maps Need To Be Redone. There Is an Intense Reluctance Among Many to Discuss These Matters Openly and Plainly and Clearly. It Is Widely Viewed As “Rude” to Do So.”

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Yesterday’s blog entry reported on an e-mail sent to me by academic researcher Wade Pfau on February 24, 2011. My response is set forth below:

Wade:

I’m responding before seeing the Bogleheads thread and the Drip Guyexchange. I want first to respond to the question “Why haven’t academics already published research about this?”

I have identified two reasons:

1) The Social Taboo against pointing out flaws in Buy-and-Hold.

We all live in communities. There are thousands of books and studies and calculators that were developed pursuant to the Buy-and-Hold Model, which is rooted in the Efficient Market Theory. Shiller’s research (showing that valuations affect long-term returns) discredits all that. The point is fundamental. If the market is really not efficient (if valuations really affect long-term returns), everything developed in the Buy-and-Hold Era is wrong in very significant ways. Shiller discovered that the earth is round instead of flat and all the old maps need to be redone. There is an intense reluctance among many to discuss these matters openly and plainly and clearly. It is widely viewed as “rude” to do so because so many will need to acknowledge having made mistakes when word gets out. We all are aware of these social pressures and make an effort to be responsive to them (even me! — the reason I am less responsive than most today is that I have seen through personal experience that tolerance for a  lack of clarity can keep things going around in circles endlessly).

2) Cognitive Dissonance

It should not be concluded that because there are many who have a vested interest in blocking knowledge of how stock investing works that these many people are corrupt. Humans have an immense ability to rationalize — “a man hears what he wants to hear and disregards the rest,” according to famed asset allocation strategist Paul Simon. People don’t think about things they don’t want to know. Until the crash, most wanted to believe that Buy-and-Hold worked. So they avoided thinking about all the reasons why it cannot work. People can only come to learn about this stuff gradually over a long period of time by asking lots of questions and slowly taking in new ways of thinking about stock investing. Unfortunately, the Social Taboo has made this impossible for many years. The level of hostility that has been generated by challenges to Buy-and-Hold has made it difficult for those trying to understand both sides to make sense of things.

There are lots of signs that things are starting to change. Let’s hope that they change fast enough for us to be able to get the word out before a failure to address these matters puts us all in the Second Great Depression. I’m optimistic (perhaps willfully so).

Rob

Academic Researcher Wade Pfau: “Now That I Am Accounting for Risk, I Am Even More Amazed by How Well Valuation-Informed Indexing Works… Why Haven’t Academics Already Published Research About This?”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on February 21, 2011. He responded on February 24, 2011.

He said: “Now that I am accounting for risk, I am even more amazed by how well Valuation-Informed Indexing works. I’m so confused by why Fisher and Statman didn’t consider risk in their idiot switching tests.  VII is much less risky by pretty much any standard I consider.  I must wonder… did I make a mistake somewhere?  Why haven’t academics already published research about this?”

Wade provided a link to a Bogleheads Forum thread he started:

http://www.bogleheads.org/forum/viewtopic.php?p=970705#970705

He also set forth a link to an exchange he had with Drip Guy, one of the lead Goons:

http://www.bogleheads.org/forum/viewtopic.php?t=68683

He said: “He never responded to me.  But have you ever heard him express before that he essentially has a backup plan for the 4% rule, and that is to start cutting withdrawals should the need arise?”

“”If You Can Get Over the Fact That He Compared You to the Potato Famine and the Black Plague, I Think You Can Find a Compliment Buried in His Remarks”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on February 16, 2011. He responded on February 21, 2011.

He noted that there was a thread on safe withdrawal rates in progress at the Bogleheads Forum. He said that a poster named “sscritic” mentioned me. He also said that: “If you look carefully at DRiP Guy’s response and can get over the fact that he compared you to the potato famine and the black plague, I think you can find a compliment buried in his remarks.  Is it your first complement from him?  Perhaps progress is being made.”

Wade sent a follow-up e-mail in which he said that he now realized that he had misunderstood Drip Guy’s comment. He explained: “I thought he was complementing your idea of SWRs and valuations, but maybe he was just acknowledging the development of the Bogleheads board.”

My response is set forth below:

Wade:

That’s okay. I’m grateful for your kindness in letting me know of what you thought for a time MIGHT have been a compliment from Drip Guy.

The fact that I was responsible for the founding of the Bogleheads Forum amazes me. it is not possible! Buy yet it is so!

There have been a few times at the Goon Central board where Drip Guy has put forward words that could be interpreted as backhanded compliments of me (mixed in with heavy helpings of abuse). There was one not too long ago where he said that, even if I am right that all of what I say follows from Shiller’s findings, Buy-and-Hold still is not a Get Rich Quick approach because those following it did not intend to be following a Get Rich Quick approach. Implicit in his post was a hint that he does not entirely dispute my claim that what I say follows from what Shiller says (he would not acknowledge that publicly, of course).

The Bogleheads SWR Wiki contains unacknowledged backhanded compliments of me too.

It’s always nice to hear from you. You keep fighting the good fight!

Rob

“I Was Thinking About Taking Taylor [Larimore] to Task for This [Mischaracterizing Bogle’s Position]…. Other People Have Already Pointed It Out to Him and He Doesn’t Seem to Care.”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on January 20, 2011. Wade responded the next day.

He said: “If you do have any suggestions about how I explained why long-term market timing works, but not short-term market timing, I would love to hear it.” He added, though, that he did not want me to have to retype points I had already made in materials at my web site. He explained that: “I think this is something you’ve addressed in your various articles, and I will read everything before finalizing my paper.”

Re Larimore’s mischaracterization of Bogle’s position, Wade said: “I was thinking about taking Taylor to task for this, but in the end I’ve decided not to. That guy is over 80 years old and he seems to be a bit of a follower. I don’t really feel a need to argue with him at this point. Especially since other people have already pointed it out to him and he doesn’t seem to care.”

Wade told me that he had “big news.” He had posted preliminary results of his research:

http://www.bogleheads.org/forum/viewtopic.php?t=67093

He noted that “Richard disappeared after I took him to task about being full of it with regards to ‘standard statistics.’ ” He explained that: “I think on those message boards that all those guys repeat that mantra so much that they do not think it is standard statistics, when in fact the issue of rolling periods is a rather advanced topic well beyond the reaches of Statistics 101, and their assumptions are not necessarily right.”

Academic Researcher Wade Pfau: “Two Papers by FIsher and Statman Are Still All I Can Find That Provide Evidence Against Long-Term Market Timing”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on January 17, 2011. Wade responded on January 20, 2011.

He described a thread that he started at the Bogleheads Forum:

http://www.bogleheads.org/forum/viewtopic.php?t=67093

He said that it was not his intent to start a debate on the merits of Valuation-Informed Indexing since he hadn’t yet finished his research paper. However, he wanted to know if anyone was aware of studies concluding that Valuation-Informed Indexing does not work. He explained that: “Once I finish my study, I would like to refer to the concept as Valuation-Informed Indexing, but I called it long-term market timing in this post since I really was trying to avoid controversy and just uncover more background reading materials.” He reported that: “Two papers by Fisher and Statman are still all I can find that provide evidence against long-term market timing.”

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: Bogle in Many Cases Has Said Things “Not All That Different From What You Said”

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Yesterday’s blog entry set forth the text of a an e-mail that I sent to academic researcher Wade Pfau on December 16, 2010. Wade responded the next day.

Wade said in his December 17 e-mail that: “In thinking about it further, I owe you further apology as my comment was based on a misunderstanding about your past claims.” He explained that: ” I understood that you meant this as the safe
withdrawal rate, but somehow I still confused myself into thinking that this number represented your prediction for the actual withdrawal rate.  If it was a prediction, then naturally you would need to indicate the uncertainty surround it.  But it is not a prediction.  It is just a lower bound that should be safe. So you don’t have to be so worried about its precise value. ” He speculated that the person who had suggested in an earlier thread at the Vanguard Diehards board that I had been dogmatic in my posting “made a similar mistake” and that this mistake “confused my ability to understand your response.”

He added that “actually I am a neophyte to the whole withdrawal rate debate.  I didn’t even know about Bengen or the Trinity study until July” but “now I am quite interested in this topic.”

Wade expressed confusion over “why some Bogleheads are so threatened by using valuations.” He noted that John Bogle has in many cases said things “not all that different from what you said.”

He concluded the e-mail with a kind compliment. He said: “I should also just say that you are a very good writer….Your writing really commands attention.”

The text of my response is set forth below:

Wade:

That all sounds good.

Please enjoy your week away. I expect to send you an e-mail next week that will provide a link re your question about the timing of John’s work and perhaps address a few other substantive points. But I of course understand that you will not see it until the following week.

Bernstein’s discussion of SWRs is on Page 234, if I recall correctly. I have cited it so many times over the years that I have the page number memorized. The claim that I often make is that the Old School SWR studies are “analytically invalid” and I often cite Bernstein’s words in support of this claim. One of my fellow community members who does not like me using that phrase sent Bernstein an e-mail asking him if he agrees that the Old School studies are “analytically invalid.” Bernstein said that “of course” they are analytically valid. But he followed that up by saying that anyone giving thought to using one of them to plan a retirement would be well-advised to “FuhGedDaBouDit!” That’s the point that I mean to convey with the claim that they are “analytically invalid”! The purpose of the studies is to help people plan retirements. They are not designed in such a way as to be able to do that effectively. So in my eyes they are analytically invalid. They do not the job that they were set up to do.

It may make you feel better to know that John Walter Russell also made the mistake of confusing the number that is at the lower bound of the confidence interval (the SWR) with the number most likely to turn up. John and I exchanged about 10 e-mails on this point a long time ago. I agree with you that there’s a good chance that the other poster in the thread you read was making a similar mistake. This is not intellectually difficult stuff (at least not the parts that I understand — I have no background with the statistical tools). But there is an undercurrent here that is EXTREMELY counter-intuitive. I have seen it throw many smart and good people off track. I of course would like to be able to figure out how to communicate the points in a way that avoids the confusion that enters into just about every discussion of these matters. I have picked up some clues as to how to do that over time. But it is the hardest job that I have ever tackled in my life. The way to spin this in a positive way is to observe that, if the confusion is today very deep, the prospect of making a giant leap forward in our understanding of how stock investing works once we overcome the confusion is also great.

Your words about John Bogle are 100 percent right on! It was by reading Bogle’s “Common Sense on Mutual Funds” in the mid-1990s that I got on the track that I am now on. I am the biggest Boglehead in the world. The investing strategy that I recommend is called Valuation-Informed Indexing. It is a mix of Bogle’s best ideas and Shiller’s best ideas. I say that Bogle and Shiller go together like chocolate and peanut butter. The thing that I say that some view as anti-Bogle is that Bogle made the biggest mistake in the history of personal finance when he said that it is possible to “Stay the Course” without being willing to change your stock allocation in response to big valuation shifts. But I don’t see it as being such a big deal that Bogle made a mistake. We obviously all make mistakes and Bogle’s ideas have led to many breakthroughs (including Valuation-Informed Indexing — there clearly would not be any VII today without the insights contributed by Bogle).

It may be that some of the anger felt by some of the Bogleheads is BECAUSE my ideas are so influenced by Bogle’s. The angry ones could dismiss my ideas easily if they differed in many ways from Bogle’s. Because they are so closely related,
it is hard for them to dismiss them. Yet the strategy recommendations are very different. In January 2000, a Valuation-Informed Indexer would probably have been going with a stock allocation of about 10 percent. A Buy-and-Holder would
probably have been going with 70 percent. That’s a big difference! My only difference with Bogle is over the valuations question, but valuations are so important that we often end up in very different places.

As you note, it’s not that Bogle rejects the idea that valuations affect long-term returns. I learned this from him! It’s that Bogle does not IMPLEMENT the insight. He SAYS that valuations matter. But his allocation recommendations do not take valuations into account. That’s the entire deal. That’s the only real question in dispute in the eight-year-long debate.

Bogle said in an interview that he thinks VII can work:

http://arichlife.passionsaving.com/2009/07/28/bogle-says-valuation-informed-indexing-can-work/

But when I sent him an e-mail asking for his help in dealing with the abusive posting, he did not respond:

http://arichlife.passionsaving.com/2009/07/30/my-hope-is-to-persuade-you-to-steer-the-indexing-revolution-to-a-more-promising-path/

Please have a great week away from all this and perhaps we will be able to talk over some ideas for further research when you get back. There are all sorts of possibilities. I can assure you that I had zero idea what I was getting into when I put up that first post back on the morning of May 13, 2002. This is a deep well!

One last point. Over the years I have had a number of people ask me about international SWRs. It sounds like your recent paper will go a long way to answering their questions. I will definitely be checking it out and linking to it in future days.

Rob