Bogleheads Guide to Investing

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?”

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?”

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.

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.”

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!”

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.”

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.

Taylor Larimore, co-author of The Bogleheads Guide to Retirement Planning, on Wednesday acknowledged that his book contains errors in its discussions of stock investing risk.

He didn’t say the Three Magic Words. But he inched up closer to doing so than any long-time advocate of the Buy-and-Hold Model has done before (to my knowledge).

Taylor’s words came in a thread at the Bogleheads.org board entitled “The 50 Percent Fallacy.” A community member named “Tadamsmar” launched the thread, saying: “I wonder if there are any Bogleheads here who have made an attempt to square their philosophy of investment risk on the facts rather than on a fallacy? If so, please speak up.”

Tadamsmar noted that Page 142 of the Bogleheads Guide asserts that a 50 percent loss is the maximum loss that can be suffered by stock investors. This is of course a wildly false claim. The average loss on the three earlier occasions when stock prices went to double fair value is 68 percent real. On the one occasion when the P/E10 level went above 30, we saw a drop in stock prices of 80 percent real. In the late 1990s, the P/E10 level went to 44, far above what we have ever before seen in U.S. history.

Larimore responded defensively. He claimed that: ” Nowhere does the book say stocks (or any investment) can’t fall more than 50%.”

Numerous other defensive comments were posted. But some reasoned points were offered as well. “DBR” said: “Whether the Bogleheads book literally presents false information at that point is arguable. On re-reading, I can certainly see how a reader relying on no other sources of information could be mislead by the discussion presented there.”

After extensive discussion and obfuscation, Larmore acknowledged: “You are right. Figure 9.1 in the book should not use the words ‘Maximum Loss.’ Thank you for the correction.”

It’s a start. Eight years after we discovered the analytical errors in the Old School Safe Withdrawal Rate Studies, we have not heard any of the authors of the Old School studies or calculators make that clear an acknowledgement of their mistakes.

A few posts later, Taylor returned to Defensive Mode. He said: “Over two dozen Boglehead retirement and financial experts contributed their time and knowledge to our second Bogleheads’ Guide without renumeration. Like any book, it contains mistakes and some things may not be perfectly clear to every reader. Despite its shortcomings, customer reviews at Amazon give our book a 5-STAR rating and it is recommended by many reviewers, including Vanguard. Please tell us what you like about the book.”

Tadamsmar observed in response to one of the many defensive comments put forward by Boglehead.org community members that: “If I make a correct statement and people keep coming back and telling me I am wrong, then I guess this might continue forever.”

Taylor has claimed on earlier occasions that the reason why he favors a ban on posts pointing out the flaws in the Buy-and-Hold Model is that Buy-and-Hold is the only investing approach rooted in “science” and “academic research.”