A Rich Life

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

Early Retirement Extreme Forum: Is Efficient Market a Theory, Hypothesis, Fact, Law or Notion?

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I recently engaged in a discussion of the Efficient Market Theory at the Early Retirement Extreme Forum. The thread is titled Is Efficient Market a Theory, Hypothesis, Fact, Law or Notion?

Juicy Excerpt #1: I want to be fair in my descriptions. I don’t want to underplay the extent to which I believe the evidence has been misinterpreted. I believe that this misinterpretation has caused a great deal of misery. So I want to be firm on this point. But I also want to be fair. I don’t want to be calling something a nation if it is really a hypothesis, or calling something an hypothesis if it is really a theory, or whatever. My question is — Is there anyone who can say what the true status of the Efficient Market idea is?

Juicy Excerpt #2: A hypothesis that holds true under certain conditions. It has never been proven mathematically…. You could try to prove EMT empirically and then say via scientific induction it will hold true forever more. But the past is a terrible way to predict the future, and definitely doesn’t provide the needed proof to give something the title of “theorem”. So I therefor say “not a theorem” and a “hypothesis”. You could then try and argue that the hypothesis has been disproven. I’d say it has, but you could say it holds true under certain conditions (like if you watch the market > 40 years).

Juicy Excerpt #3: The efficient market idea is best described as a hypothesis. It simply does not has the same level of evidence and support to be a theory. However keep in mind to be classified as a theory you need an overwhelming amount of evidence including many making many predictions that could be falsified to prove the theory wrong but were not. That said, there is still a strong amount of evidence for the emh, but not nearly at the level of say the theory of evolution. The way I view the emh is that it is a model that describes/predicts how some aspects of the market work. But to paraphrase the statistician Box, all models are wrong but some are useful.

Juicy Excerpt #4: You, Jacob, and Shiller have unveiled some things for me on finance. I moved 1/2 my 401k into “safe” funds for long term timing (Although, I really enjoyed September after I sold near end of August:)). I don’t feel bad though. I made the move entirely based off my reflection on risk tolerance. It occurred to me that I was not willing to potentially lose half my wealth again to mumble “in the long term” after reviewing how history repeats itself. Especially now that I soon plan to ERE.

Juicy Excerpt #5: Personally, I think the existence of bubbles, especially the ginormous tech bubble of ’96-’00 and the recent housing bubble, basically proves the failure of an efficient market. That said, I would rather gamble on solid value stocks and solid dividend paying stocks than to sit out the market until the market as a whole drops down to historically “fair” valuations.

Rob on the Hot Seat

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I mentioned on a thread at the Early Retirement Extreme forum that J.D. Roth at the Get Rich Quickly blog once sent an e-mail to all readers of his forum asking that they not respond to my posts. A community member named “Alex” said: “Rob — I have to ask…What do you say that’s so controversial?”

Good question!

The response that I provided over there is set forth below:

You’re going to be sorry you asked, Alex! I want to answer your question. But I don’t want to hijack the thread. If anyone thinks it would be a good idea to pull this question and response off into a separate thread, that makes perfect sense to me.

I say that valuations affect long-term returns. It’s not even a tiny bit controversial from one way of looking at things and it is the most controversial thing ever said from another perspective.

The history is that the Buy-and-Hold Investing Model was developed at a time when people believed in the Efficient Market Theory, which posits that stocks are always priced properly. Thus, Buy-and-Hold does not tell people that they need to change their allocations when prices go to insanely dangerous levels. Shiller did research in 1981 showing that this is not so, that valuations matter. If Shiller is right (I strongly believe that he is), then the Buy-and-Holders are wrong. The two ideas (that valuations matter a great deal and that valuations matter not at all) are in conflict. Accepting one or the other of the root premises as true leads to the development of an opposite model for understanding how stock investing works from the model you would have if you went with the other option.

As a society, we have been working hard for 30 years to avoid dealing with the implications of Shiller’s findings. If Shiller is right, then 90 percent of the retirement planning advice we have been giving for 30 years is wrong. So is 90 percent of the asset allocation advice. So is 90 percent of the risk management advice. Most of the investment calculators on the internet today get the numbers wildly wrong. And on and on.

I don’t care what others believe. It is of course none of my business. But I do think that I have an obligation to state my own views sincerely. So, when I am in a group that is talking about retirement planning, I always point out that the numbers in the existing studies all get the numbers wildly wrong (they don’t account for the valuation level that applies on the day the retirement begins). I don’t do this to hurt anyone’s feelings. I just do it because it seems clear to me that it really is so and I have made many friends in all the communities in which I have participated and I think that it is important that people at least have access to accurate retirement planning guidance, whether they elect to follow it or not.

If you think Shiller is right, it follows that it was the promotion of Buy-and-Hold that caused the economic crisis. The intuitive thing would be for people to lower their stock allocations when prices go to insanely dangerous levels. Why wouldn’t they? But Buy-and-Hold says there is no need to do this (because it is rooted in the now-discredited Efficient Market Theory, which says overvaluation is a logical impossibility). So people kept buying even after prices went nuts. By 2000, stocks were overvalued by $12 trillion. Prices always revert to the mean after 10 years or so. So we put ourselves in circumstances in which an economic crisis was assured. The loss of that $12 trillion in Pretend Money is today killing us.

The Buy-and-Holders don’t want to deal with any of this. So, when I bring it up, people get excited. If there were a way to talk about the topics I write about (saving, investing) without bringing any of this up, I would do it. But it is impossible. How can you tell people how to save or invest effectively without ever talking about asset allocation strategies or retirement planning or the cause of the economic crisis or what we need to do to recover from it? This thing is so huge that it is unavoidable.

It’s a strange, strange story, Alex. It’s like I got myself involved in a nuclear explosion. What’s going on is that Buy-and-Hold was the first attempt to rationalize the investing project. Instead of giving their subjective take, Buy-and-Holders cite academic research and historical data. That part is wonderful. The problem is that, when you cite research and data, you need to update what you say when the old stuff is discredited. Numbers are objective, so when they are wrong they can be shown to be wrong. A lot of the big-name Buy-and-Holders don’t like the idea of acknowledging that they got important things wrong. They view it as bad from a marketing perspective. So this thing goes on and on.

Anyway, it drives a lot of people crazy. I get very strange reactions. I have had numerous people ban me from their sites and then write me e-mails apologizing and telling me that they read all my stuff and think my work has huge value. This hasn’t happened just one time, it has happened numerous times! I have three blurbs on the back of my saving book, people praising me to the sky. Two of the people who wrote those blurbs banned me from their sites after I started posting on investing even though numerous big-name experts have confirmed what I have said about investing. Can you beat that?

I believe that as a society we need to deal with this Efficient Market thing. We need to have a national debate in which everyone participates and decide once and for all whether valuations matter or not. If we get to a point where there is a consensus that they do (the evidence is overwhelming and there is no evidence on the other side — the Efficient Market thing was always just an hypothesis, there was never any study supporting it) , we can fix all the textbooks and the calculators and the studies and I believe that we can enter the greatest period of economic growth that we have ever seen. If we don’t fix this stuff, the numbers indicate that we are in a lot more trouble than nearly anybody recognizes today. By persuading millions to invest in precisely the opposite of the way that works (I don’t say this was done intentionally, but still…) we have placed ourselves in quite the little sticky fix.

My belief is that, as things get worse, more people will open up to consideration of new ideas, and we will eventually get to a point where we are able to turn everything around. I have already seen some signs that that is starting to happen. But I think it would be fair to say that it is a maddeningly slow process!

Please understand that I did not ask for this job of saving the world with my two bare hands, Alex. They were looking for volunteers and I wasn’t paying attention and everyone else stepped back and that make it look like I had stepped forward. Now this is my life!

Rob

Early Retirement Extreme Forum: Risk Revisited

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I recently started a thread at the Early Retirement Extreme Forum titled Risk Revisited.

Juicy Excerpt #1: I view the attitude toward risk that Kevin is describing (he is accurately describing the Buy-and-Hold approach) as exceedingly dangerous. In all other areas of life endeavor, we think of risk as something to be avoided. When it comes to investing, we think of risk as something to be sought out. I believe that this is why we are in an economic crisis today. We have taught millions of middle-class people to seek out risk and the result is that we have collectively taken on so much excessive risk that the losses have become big enough to crater the entire economy. We need to rethink this risk question!

Juicy Excerpt #2: But then Bernstein spends the rest of the book showing how it was impossible to win by purchasing individual stocks or to time the market and that the best way to invest is to buy and hold in specific asset allocations. So, in other words, even as he said the market appeared to be priced way too high, still the best thing to do was to buy into it.

Juicy Excerpt #3: I believe that we are working our way through an elaborate social dance. How do we get to the point where it becomes possible to say openly that we all goofed up? I believe that once we get that part of the job out of the way, the rest is going to come easy.

Early Retirement Extreme Forum: Is Buy-and-Hold Just a Marketing Pitch?

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I recently started a discussion-board thread at the Early Retirement Extreme site titled Is Buy-and-Hold Just a Marketing Pitch?

Juicy Excerpt #1: I think this may be the warmest reception I have heard to my criticism of Buy-and-Hold at any place on the internet. Usually, I duck immediately after pushing the “Send” button to avoid the bricks being thrown at me. Here, I almost feel that in fairness I should jump in and defend the Buy-and-Hold position!

Juicy Excerpt #2: I don’t think “Buy and Hold” index investing is a marketing ploy. I think the authors who “push” the philosophy genuinely think it’s a good idea and base their opinion on “long term” data.

Juicy Excerpt #3: I’m no EMT fan. But which specific 1981 research are you referring to?

Juicy Excerpt #4: Anyone can make a mistake, Maurius. One of my biggest fears in writing about personal finance is that someday I might make a mistake that would cause someone to suffer a serious financial setback. Do you know how I deal with that concern? I acknowledge that I do not know it all. I invite people with different viewpoints to post at my site, to challenge my claims. I correct errors as soon as they are brought to my attention. That’s what John and all other Buy-and-Holders should be doing.

Juicy Excerpt #5: I ask you (and please take this in the most innocent manner possible): what do you have to gain if you help “the people”? Are we talking friendly help here, or is it professional help (fee-based financial advice or something) Just want to understand where you’re coming from before I think about engaging you on any of the specific points you’ve made.