A Rich Life

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

Academic Researcher Wade Pfau: “No Matter What I Try, Valuations-Based Strategies Tend to Produce the Same or Greater Returns at Lower Risk Than Fixed Allocations”

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Yesterday’s blog entry reported on an e-mail sent to me by academic researcher Wade Pfau on January 21, 2011. The text of my response follows:

Wade:

I would of course be thrilled if you called the paper “Valuation-Informed Indexing.”

There is no question in my mind that the paper MERITS inclusion in the Journal of Finance. I have no idea how these things are decided, so I have no idea whether they would take it. But this is as new as it gets and as important as it gets and as solid as it gets. So by rights it should be in the #1 journal.

Rob

My next e-mail to Wade was sent on February 22, 2011. The text follows:

Wade:

I came across this

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2011/02/21/stay-out-of-the-room.aspx

today. Ed is a great guy. He participated in a long interview/discussion with John Walter Russell and me at the old SWR Reseaerch Group board a good number of years ago. Actually, all community members were welcomed to participate. But the discussion was boycotted and those who showed an interest in participating were intimidated into not doing so. All the same, Ed and John and I had a great time talking about all the various issues.

Ed’s new book looks like it is going to be a barn-burner!

Rob

Wade responded the same day. He said that he intended to read both Easterling’s old book and the new one.

His e-mail stated: I’ve been plugging away with the valuations stuff.  No matter what I try, valuations-based strategies tend to produce the same or greater returns at lower risk than fixed allocations.  I’m using a number of formal risk measures to show this now.”

He also noted that Felix Salmon has written a review of his safe savings rate paper.

In a follow-up e-mail, Wade said that he did not plan to use my terminology of referring to allocation shifts based on valuations as “strategic” rather than “tactical,” which is the common practice, but said that he wanted to make note of the distinction in a footnote to the paper.

In my response, I noted that Felix has once written a kind review of The Stock-Return Predictor.

In his response, Wade linked to Felix’s review and commented “Yes, that’s a good one.” He observed that Felix did not refer to the allocation shifts as “market timing,” and offered the view that this is “nice to see.”

“Wall Street Has Polluted the World with Self-Serving Theories. The Entire Debate Is Debased & Devalued”

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Reuters Blogger Felix Salmon has written an article applauding the retirement planning approach developed by Wade Pfau and described by him in the blog entry posted here a little over a week ago titled Wade Pfau: This Paper…Suggests that the Traditional Approach to Retirement Planning is Counterproductive and Possibly Damaging.”

Juicy Excerpt #1: Pfau’s insight is that thanks to mean reversion, the number you need at the end of a bear market is actually lower than the number you need at the end of a bull market — if the market’s about to head up, your retirement savings can grow even post-retirement, while if the market is about to fall, you’re liable to lose much more than just your annual expenditures.

Juicy Excerpt #2: Instead, says Pfau, stop thinking about stock, and just think about flows. Save a set percentage of your salary every year, stick to it, and, it turns out, you’ll be fine:

Juicy Excerpt #3: Investing can be exciting, especially when it’s done wrong. You follow the markets rising and falling, you obsess about your retirement-fund balance, you rotate out of this and into that, you read books and magazines and blogs to try to learn more about what to do. You might even, in a moment of weakness, find yourself watching CNBC. Budgeting, by contrast, is like going on a diet: it’s a drag, and it’s hard to get any pleasure or excitement out of it. But the latter is much more likely to get you well-set in retirement than the former.

Juicy Comment #1: Investing would be so easy if we could just assume that markets are mean reverting, like Pfau. Unfortunately, Taleb’s insight, that mean reversion is bullshit, is far more persuasive.

Juicy Comment #2: Subzero annualized real total returns over 10 year periods can persist for up to a decade – it only recently went below zero in 2008.

Juicy Commeent #3: The 8% returns assumed by many pension fund managers today are ludicrous at best and criminally fraudulent at worst. Just another example of the governing class of people gaming the system to buy themselves another handful of years raking money off the top before their bubble world bursts.

Juicy Comment #4: My other source of valuation is to pay attention to what insurance companies are willing to payout in annuitized payments. They seem to be the only part of the financial sector living in the same world that the average person inhabits.

Juicy Comment #5: If Wall Street had not been polluting the the world with self serving theories about stock returns “for the long run,” 90% of the posts on this thread would not be here. The entire debate is debased and devalued. Hopeless.

Juicy Comment #6: Original idea for you, MGK: asset prices are meaningless, only cash flow counts. Cash flow is the life blood of any business, any household. Cash flow from operations, not from financing. Whether you invest in the stock market, in bonds, in real estate, or in “hard commodities”, be certain that the free cash flow generated is sufficient for your needs. Anything beyond that is speculative.