Yesterday’s blog entry reported on an e-mail that I sent to Academic Research 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:

Re the chart.

It’s certainly eye-opening.

My circumstances are odd. I was saving like a madman in the late 1990s so that I could quit corporate employment and build an internet business. I paid off my mortgage in early 1996 and went to a zero stock allocation in the Summer of 1996
because I was aiming to quit my job in 2000 and a crash would put off that possibility for many years. I put the money in TIPS and IBonds paying 3.5 percent real. I experienced only a small downside for 1997 and 1998 because the amount of money that was not in stocks was small (the amount I took out was about $30,000 –the rest of my savings had gone to paying off my mortgage). But I saved $88,000 in the last year of corporate employment so the amount that I protected from stocks in 1999/2000 (when stocks were most dangerous and paid the lowest long-term returns) was big.

I say all this because I was asked HUNDREDS of times during the nine years of discussions whether my crazy ideas had worked for me personally. John Walter Russell and others did the calculations. The numbers have been showing for a long time (probably back to 2003 or so but I don’t have precise recall) that this worked for me personally (because I didn’t take much of a hit from 1996 and 1997). No one ever cared! Not one of the people who demanded to know how I did ever said a word of congratulations to me after seeing with a numerical analysis that I have been up for a long time and keep going farther and farther ahead with the passage of time.

I see this as being of huge significance. It tells us that Buy-and-Holders do not employ reason to figure out how to invest. They employ rationalizations to defend Buy-and-Hold from criticism. This reality overrides everything else. Emotions trump numbers. So long as that is so. there is no logical case that can ever win the day. The emotional realities are the dominant realities.

Now we see the greatest benefit of Valuation-Informed Indexing. it’s not that it offers much better long-term returns. it’s not that it dramatically diminishes risk. The greatest benefit of all is that it provides for EMOTIONAL BALANCE.

The thing that causes investors to become emotional is valuation changes. All valuation changes are rooted in emotion (this is so by definition — the rational thing would be to price stocks at fair value). Each upward valuation move makes
investors that much more emotional because they want to be able to count those gains as real but their common sense tells them that they cannot possibly be real. So a cycle of self-deception sets in that over time causes valuations to get more and more and more out of control. Eventually, prices get so high that the only way the market can return to efficiency (the market wants to be efficient, it just has not in the past been able to overcome the influence of those who believe in Buy-and-Hold/Get Rich Quick “ideas”) is for prices to crash.

The Valuation-Informed Indexer does NOT get excited by price increases. Every price increase adds to his portfolio value, which is seen as a plus. But every price increase ALSO lowers his expectation of his long-term return from that point forward, which is a negative. Valuation-Informed Indexers DON”T CARE whether prices go up or not. Once investors come to not care whether prices go up or not, they are no longer going to feel any emotional desire to push them up. Once VII becomes dominant, bull markets become a logical impossibility.

Once bull markets become a logical impossibility, bear markets also become a logical impossibility (there has never been a secular bear that was not caused by a secular bull that preceded it).  Once bear markets become a logical impossibility, economic crises become far less likely (each of the four economic crises we have seen from 1900 forward were preceded by P/E10 levels above 24 — there has never been a P/E10 level above 24 that did not bring on an economic crisis). Greatly reducing the number of economic crises we suffer would permit our economy to move forward at a far more rapid pace (we would not need to rebuild it every 40 years or so). This is another game changer.

The way to make your point more dramatically (I understand that people would scream if you did this) would be to show the effect of a price drop of 65 percent from where we stand today. That would take us to a P/10 of 8, which is where we have always ended up in the years following a trip to insanely dangerous price levels.

Another way to make your point more dramatically would be to have the amounts not invested in stocks invested in TIPS paying 4 percent real. Such TIPS were available to those who understood that valuations affect long-term returns. Why would such investors deliberately seek out low returns? The logical thing would be for them to obtain the highest non-stock return available to them at the time they were looking for an alternative to stocks.

Drip Guy’s comment is that timing always shows promise for a time and then is shown not to work again. The reality is just the opposite. It is Buy-and-Hold that always shows promise for a time and then is shown not to work. People believe in Buy-and-Hold because they gave it credit for the good returns from 1982 through 1995. Those returns had nothing to do with Buy-and-Hold. Stocks always provide good returns when low or moderately priced.

The benefit of using the historical data as guidance in the formation of investing strategies is that it takes you outside the emotions of the day. The data includes both the irrational exuberance of bull markets and the irrational depression of bear markets. Reporting accurately what the historical data says permits us to think rationally about stock investing for the first time.

We could never do this before the 1970s because index funds were not available. And we could not do it from the 1980s through the crash because the first data-based approach was rooted in a false assumption that overvaluation is not a real phenomenon (that the market is efficient). We now stand on the threshold of the first time in history when people will be able to develop a rational and data-based and simple and safe way for millions of middle-class investors to tap into the wealth-creation potential of stock market investing.

The life-affirming implications that follow from this are so vast that they cannot be overstated, in my assessment. It just gets better and better and better and better once we get over that hurdle of opening up the internet to honest posting on the academic research findings of the past 30 years (very much including yours!)

Rob