A Rich Life

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

Director of Center for Health Law, Policy and Practice Scott Burris: “The Fact that Aggressive and Short-Term Market Timing Was Unproductive Did Not Mean That There Were Never Times That It Would Be Wealth-Maximizing to Get Out of the Market”

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I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Scott Burris, Director of the Center for Health Law, Policy and Practice at Temple University Law School,  sent me a response saying: “I found the piece interesting — what one would expect from a Temple grad. I read the Pfau paper. Good luck with your endeavors.”

I wrote back: “Thanks for your kind wishes!”

Scott replied:

“This is what I wrote to my investment advisor. Did I correctly understand the argument?

“The Pfau paper addresses a point that, in my casual observation of the market and investment strategy, had also occurred to me: that the fact that aggressive and short-term market timing was unproductive did not mean there were never times that it would be wealth-maximizing to get out of the market. The challenge, of course, was to figure out the moment. This piece tests the use of a ten year average of PE ratio, and finds results comparable to buy-and-hold when adjusted for risk. This approach seems particularly applicable to people hitting their sixties, for whom shorter-term risks matter more. It’s notable, for example, that someone who’d followed this approach for a few decades would have gone to t-bills in 2009 and so, if they were about to retire, would have been richer and happier in 2010-11 and would still likely have been back in stocks in time to get some of the recent appreciation. Finally, in an era of economic financialization and weak regulation, one might expect a return to our pre-1929 pattern of frequent boom and bust cycles, suggesting, again for the retiring person, more of the unfortunate short-term effects of volatility.”

I replied:

Scott:

Yes, you understand the point. All of the things you say in that paragraph are accurate.

My personal view is that there is an even broader implication. The root question here is: How are stock prices determined? The conventional view is that it is a day’s economic and political developments that determine whether prices go up or down and by how much. The Shiller/Pfau research shows that this conventional view cannot be accurate. If the conventional view were accurate, prices would follow a random walk in the long term, just as they do in the short term. The research shows that long-term prices are highly predictable. The really important question is — How can that be? How can we know years in advance what stock prices will be?

The answer is that investors hold two opposite ideas in their heads at the same time. We all have a Get Rich Quick urge. So we very much want to believe that temporary and crazy bull market prices are real. We also all have a Common Sense urge. The Common Sense urge tells us to reject the temporary and crazy bull market prices. We SUPPRESS the Common Sense urge for the length of the bull market. Eventually, though, the Common Sense urge strengthens enough to gain the upper hand. That’s when prices crash. Crashes make no logical sense. All price changes should be gradual if the market is responding to economic or political developments, which play out gradually over time. But emotional changes can be violent. Crashes make sense in a world in which the dominant influence on price changes is investor emotion.

This means that 80 percent of the research being produced today looks at the wrong things. Most investing research is numbers-oriented. If it is an understanding of investor emotion that determines success or failure, we need to be looking at all sorts of thing that today we ignore. For example, we shouldn’t be blaming the stock crash on our economic problems. It is our lack of understanding of how investing works that caused our economic problems. Trillions of dollars are tied up in the stock market. The stock market is part of the economy. To successfully manage the economy, we first need to permit ourselves to learn more about how stock investing works. The first step is acknowledging that we did not know it all before Shiller and Pfau did their research.

This turns everything we think we know about stock investing on its head. It’s because the implications are so far-reaching that people are reluctant to discuss this. But the news is good, not bad! It’s true that we got a lot wrong. But that just means that we have lots of room for improvement. We have ignored Shiller’s research for 30 years. Imagine where we would be in the computer technology field if we determined in 1981 that every advance possible had already been achieved and that no further advances would be permitted. That’s what we have done in the investing field. If we open up discussion on all the advances that we achieved intellectually over the past 30 years, we would see 30 years of knowledge advancement in a very short amount of time (and these are the best 30 years of knowledge advancement we have ever seen in this field).

It’s impossible to overstate the importance of this (presuming the insights are valid). Look at the risk chart Wade provides on Page 8 of his paper. The Portfolio Drawdown Percentage goes from 60 percent to 20 percent with the move from Buy-and-Hold to Valuation-Informed Indexing. That’s a risk reduction for stock investing of nearly 70 percent! For investors who index and who pay attention to valuations when setting their stock allocation, stocks are today not much more risky than Certificates of Deposit. That changes everything.

One last practical point. The best way to think about this is not to say “there are times when it is a good idea to get out of the market.” It’s not possible to know precisely the right exit and entry points. P/E10 told you that stocks were insanely dangerous in 1996 and returns were amazing in 1997 and 1998 and 1999. The way to think about his is to say “risk is greater when the P/E10 level is greater and so I need to gradually lower my stock allocation in response to increases in the P/E10 level to keep my risk profile roughly constant.” The full truth is that, while stocks did well in 1997 and 1998 and 1999, the investor who lowered his stock allocation in 1996 is ahead of the game today. And he will be farther ahead after the next crash (every secular bear market in U.S. history eventually took us to a P/E10 level of 7 or 8, 65 percent down from where we are today. We cannot pick tops or bottoms. But we don’t have to. It’s risk that matters. We MUST manage risk. Those who follow Buy-and-Hold strategies are vowing NOT to manage risk as their first investing decision. That always ends up being a terrible choice in the long term.

Rob

Valuation-Informed Indexing #130 — Buy-and-Hold Can Give Good Results for 30 Years and Still Not Work As An Investing Strategy

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I’ve posted Entry #130 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Buy-and-Hold Can Give Good Results for 30 Years and Still Not Work As An Investing Strategy.

Juicy Excerpt: The entire benefit of using academic research to guide our strategies is to help us to go beyond subjective impressions, which are heavily influenced by recent price trends. Research gives us something objective to look at. We should make an effort to rise above our knowledge of how things have played out in recent decades, look at the entire record of 140 years, and use the data to answer the more fundamental question — How does this business of investing in stocks really work in the long run?

VII #100 — Shiller Has Not Yet Given Clear Advice on How to Implement His Investing Insights

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I’ve posted Entry #100 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Shiller Has Not Get Given Clear Advice on How to Implement His Investing Insights.

Juicy Excerpt:  I have devoted 10 years of my life to the project of writing articles and developing calculators and recording podcasts and producing column entries that explore Shiller’s model. That shouldn’t be possible. In a sensible world, there would have been hundreds of Shiller-centric sites in place when I came on the scene in 2002. There weren’t any then and there aren’t any now. If anyone reading these words knows of a good site devoted solely to exploring the implications of the Shiller model (other than my own, of course), I would be grateful if you would let me know about it.

“The Terms “Buy-and-Hold” and “Get Rich Quick” Are Synonymous. Virtually All of the Risk of Stock Investing Comes from the Human Inclination to Be Drawn to a Buy-and-Hold/Get-Rich Quick Strategy”

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Set forth below is the text of a comment that I recently put to the Goon Central board:

Do these concepts look the same to you, idiot?

Yes, Drip Guy. The terms “Buy-and-Hold” and “Get Rich Quick” are synonymous. Virtually all of the risk of stock investing comes from the human inclination to be drawn to a Buy-and-Hold/Get Rich Quick strategy.

I will make an effort to explain why this is so. If you make an effort to listen, I am confident you will get it. If you permit your rage at discovering that there was a time when you did not know everything there is to know about stocks overcome your reason, you obviously will fail to get it yet one more time. I can put forward the explanation. It is necessary for you to put a tiny bit of effort into this too for the back-and-forth to bear good fruit.

Here is your definition of “Buy-and-Hold:

used to describe the activity of investing in something and then keeping it for a period of time

That’s a good definition.

Now —

What’s wrong with the idea of investing in something and then keeping it for a period of time?

What’s wrong is that this definition says nothing about whether the thing invested in offers a strong long-term value proposition or not!

Warren Buffett holds his investments for a long time. But he sure as shootin’ ain’t no Buy-and-Holder in the way that it is practiced by Lindauer and Greaney and Bogle. Buffett buys things worth buying and holds them. Lindauer and Greaney and Bogle buy stocks when they are garbage and then refuse to consider selling no matter how much holding on to garbage depletes their portfolios.

Huh?

I am not overstating things when I say that stocks were garbage in January 2000, Drip Guy.

The most likely annualized long-term return was a negative 1 percent real. TIPS were at the time offering a positive 4 percent real. That’s a return differential of 5 percentage points per year. For 10 years running. That adds up to a total loss of 50 percent of the initial portfolio size.

You are telling me that this is an acceptable investment strategy? If you truly believe that, you are insane.

This is suicide investing.

There are ten different aspects of the Buy-and-Hold package that are pure gold. As you know, I praise these aspects of the Buy-and-Hold package to the sky all the time.

But the Get RIch Quick aspect is so devastatingly bad that it overpowers all that could be good about Buy-and-Hold.

There is not one person on Planet Earth who benefits from the continuance of this 10-year-long cover-up, Drip Guy. Certainly not any Buy-and-Holders.

The Buy-and-Holders should be dancing in the streets today. They are the ones who came up with the idea of rooting one’s strategies in the academic research. The research has now taught us how to reduce the risk of stock investing by 80 percent while delivering long-term returns far higher than most people ever thought possible. We should today be in the Golden Age of Stock Investing and celebrating the Buy-and-Holders for being the ones to have brought it to us.

Where are we instead? We are living through the worst economic crisis in U.S. history, one caused by Wall Street’s relentless promotion of an investing strategy that was originally intended to be research-backed but which became the opposite of that when research was published showing that the Buy-and-Holders got one thing horribly, horribly wrong and the Buy-and-Holders reacted not by fixing the mistake but by adopting a policy of engaging in defamation and death threats and board bannings and smear campaigns to block any of the millions of middle-class people whose lives are in the process of being ruined by this pure Get Rich Quick garbage from learning what they need to know to salvage what is left of their retirement hopes.

That’s brilliant work, Drip Guy. Congratulations! You’ve turned John Bogle into Bernie Madoff! You’re a true Boglehead through and though!

Heaven help us all.

Rob

What’s the Best Age at Which to Experience a Stock Crash?

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I’ve posted a Guest Blog Entry at the Barbara Friedberg Personal Finance blog. It’s called What’s the Best Age at Which to Experience a Stock Crash?

Juicy Excerpt: For young investors who have established themselves in good careers before a crash hits, the crash can actually be a big plus. Stock valuations always go to one-half of fair value before the bear market comes to an end. When stocks are priced at one-half fair value, the most likely annualized 10-year return is 15 percent real. Young investors experience small dollar losses in a crash and are then positioned to experience huge gains in the years when they are earning enough to invest heavily in the market.

The Historical Data Flips!

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Drip Guy made a good point in a post he put to the Goon Central board a few weeks ago. Ataloss argued that the reason why I say that the Old School safe-withdrawal-rate (SWR) studies are analytically invalid is that I don’t approve of relying on historical stock-return data to determine the SWR. Drip Guy quite properly responded that: “He wants to enlist ‘historical data’ to his own cause, so the inference is not that looking at history is innately bad in Hocoworld, but instead that prior studies were somehow specifically in error.”

Precisely so.

To appreciate the significance of my claim that the Old School studies are in error, it is helpful to understand the history behind development of the Old School studies.

Middle-class investors have long been anxious about investing in stocks. People have noticed that stock prices sometimes go down dramatically. Since most people hate the idea of losing large portions of their life savings, this observation quite naturally led to a widespread skepticism re the idea of investing too heavily in stocks. That was the state of play prior to the rise in popularity of the Passive Investing concept, an approach to understanding how stock investing works that is the root cause of the analytical errors in the Old School studies.

Passive Investing is irrational. It is obviously not smart to stick with a stock allocation adopted at a time of reasonable prices at a time when prices have risen to dangerously overpriced levels. So, in ordinary circumstances, no reasonable person would be advocating Passive Investing.

The reality is that many otherwise reasonable people recommend Passive Investing. It has become over the past three decades the dominant model of understanding how stock investing works. Huh? How dat happen?

What happened is that some very good ideas got mixed in with some very bad ideas. We have developed tools for analyzing the historical stock-return data that have permitted us to make stock investing a far more rational business than it had ever been in the years before these tools came to be available to us. Unfortunately, being the humans that we are, we messed up the implementation of these tools. Because of the mess-up, we ended up making stock investing a less rational business than it has even been rather than a more rational business than it has ever been. Oops!

If you have read the book Stocks for the Long Run, you know how the “rational” approach works. The idea is to look at the historical data, identify certain patterns, and assume (quite reasonably, in my view) that stocks are likely to perform in the future at least somewhat as they have always performed in the past. Following this procedure, you can make reasonable forecasts of how the stocks you buy are likely to perform.

This is a big deal. If you know how stocks are going to perform, you no longer need to be anxious about price drops. Sure, you might experience some doozies. But so what? If the claim put forward in Stocks for the Long Run — that stocks are always the best asset class in the long run — is right, price drops don’t matter so much. Price drops are temporary. Just stick with stocks, and all will be okay in the end. Don’t worry, be happy.

Most of the maxims that you have heard about stock investing over the past 20 to 30 years are the product of this “rationalizing” of the stock investing project. It is because of what they believe the historical data says that the “experts” say that no form of timing (even long-term timing) can work. It is because of what they believe the historical data says that the “experts” say that the conventional approach to buy-and-hold (sticking with a high stock allocation even when prices go so high that this becomes an extremely dangerous thing to do) is the way to go. It is because of what they believe the historical data says that the “experts” say that taking on more risk always leads to obtaining greater returns.

Wrong! Wrong! Wrong!

Passive Investing enthusiasts argue that their approach is the only rational one because their approach is rooted in the historical data. What the historical data says is not a matter of subjective opinion. It is a matter of objective fact. When you base your investing decisions on what the historical data says, you are basing your investing decisions on something solid. Passive Investing enthusiasts are not entirely wrong to claim that their approach is the only rational one; it really is more rational to focus on objective sources of information rather than subjective ones.

They are indeed wrong to say that their approach is the only rational one or even one of the rational ones, however. They are right in their rationale for making the claim. The historical data really is an objective source of information, and that really is important; objective information bits really should generally be given greater credibility than subjective information bits in investing analysis. There’s one big problem with these claims of the superiority of the Passive Investing approach, however. The analyses that back up this approach (including the research presented in Stocks for the Long Run) do not include adjustments for the effect of changes in valuations. The valuations factor is the single most important influence on long-term stock returns. Leave out that factor, and your claims to rationality break down. Leave out that factor, and all of the numbers you generate with your “research” are wrong!

The Passive Investing enthusiasts persuaded middle-class investors that it is safe to invest heavily in stocks even at times of sky-high prices. They did this because of what they saw in research that ignored the effect of valuations. Research that considers the critical valuations factor generates completely contrary findings. It is not safe to invest heavily in stocks at times of sky-high prices. It is extremely risky. Stocks are not the best asset class at times of sky-high prices. They are the worst. Hoo boy!

It is confusion over this point that is at the core of the “controversy” we have seen over the Retire Early Community’s SWR findings of recent years. The Old School studies, rooted in the Passive Investing model, say that the SWR is always 4 percent; the long-term value proposition of stocks is stable under this model. The New School studies say that the SWR ranges from 2 percent to 9 percent; the long-term value proposition of stocks depends heavily on the valuation level that applies at the day of a stock purchase, according to an analytically valid examination of the historical data.

I’m right. They’re wrong.

The Goons say it just the other way, of course. Listen to the Goons tell the story, and you will hear claims that they are right and I am wrong. That’s what makes them Goons!

I’m joking, of course. What makes them Goons is that they rely on deception, intimidation and word games to make their case. I think it would be fair to say after six years that they have no choice. I have never yet seen anyone try to make a non-Goon case for Passive Investing. The Goons have been driven to abusive posting (it is not my intent to excuse them but only to point out a partial explanation of their behavior and of our tolerance for it) by their discovery of the core irrationality of their investing beliefs. They very, very, very much do not want to change their beliefs and they have discovered that there is no rational defense of their beliefs possible.

The point of this blog entry is that Drip Guy is right in what he says in the words above. I do not find fault with those who use the historical data to assess the long-term value proposition of stocks. I love that idea! When I discovered Greaney’s web site, one of the things I most loved about it was his focus on SWRs. I get bored very quickly with hearing one expert say one thing and then another say another thing and then another say yet something else. All the blah, blah, blah leaves you knowing no more than you knew before you tuned in. The historical data tells you something solid, something you can sink your teeth into. One point re which I have always thought that Greaney nailed it was his insistence that we should rely on the historical data for guidance on when we have enough assets to be able to retire safely.

Where Greaney goes off the rails is in his claim that those who take valuations into account are “mentally ill.” I don’t buy it. Smart investors have been taking valuations into account since the day the first stock market opened for business. Warren Buffett is arguably the smartest investor who ever lived and his entire approach is rooted in performing valuation assessments.

If you love the idea of Rational Investing (I do!) but you hate the idea of failing to take valuations into account (I do again!), you cannot buy into the Passive Investing model. Yes, this model became extremely popular during the most out-of-control bull market in the history of the United States. But what chance does an approach rooted in research that gets all the numbers wrong have of surviving the most out-of-control bear market in the history of the United States (the historical data shows that bull markets are financed by a borrowing from future returns, so the largest bull markets set the stage for the largest bear markets)? Truly rational investors care about getting the numbers right. Truly rational investors do not invest passively, but in a valuation-informed way.

The historical data flipped!

That’s what happened. During the years when our visions of Getting Rich Quick through bull markets that went on forever dulled our ability to think clearly about the need to include all critical factors in our analyses of what the historical data says re long-term stock investing, we came to believe some things about stocks that cannot possibly be so. Now that prices are beginning to move a bit in the direction of fair-value price levels, our illusions are unraveling. The lesson is not that Rational Investing is a bad idea. The lesson is that Rational Investing needs to be truly rational. If you are going to use the historical data to guide your investing decisions, you need to be sure to use an analytically valid methodology to examine it.

Greaney and I are soul brothers on the question of the value of learning how to invest successfully by studying the historical stock-return data (I don’t get the sense that there are too many community members other than John and I and John Walter Russell who feel so strongly about this question). We are sworn enemies on the question of whether it is necessary to take valuations into consideration when performing an historical analysis. Greaney says that it is evidence of “mental illness” to do so. I say that it is not possible to get the numbers even remotely right without taking into account this critically important factor.

The historical data itself is objective. But those subjective humans have made it a matter of opinion as to whether all the factors that affect the question being examined need to be included in an analysis of what the historical data says on a given research topic. I like to think that there is one point re which we are all in complete agreement — those humans will do it to you every time!

Today’s Passion: Jeremy Siegel is a Dangerous Individual. I say it, so it must be so!

This Month’s Permanent Portfolio

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The great thing about studying what investors say on discussion boards is that you learn about how things work in practice, not theory.

Investors have been told for 25 years now to follow buy-and-hold strategies. And they say they do. But do they really?

I’ve seen hundreds of comments indicating otherwise. One thing I’ve seen a lot of is a rigid adherence to the idea of buy-and-hold combined with an extremely loose understanding of what it involves in practice.

There are lots of investors out there who in 1999 believed with their entire minds, hearts and souls that owning the S&P500 and the NASDAQ forever was the essence of buy-and-hold. Then the idea became to own just the S&P500 forever. Then it was the S&P and value stocks. Then the S&P and REITS. Then the S&P and small caps. Then the S&P and a global index. Then the S&P and Emerging Markets. The idea seems to be growing of late that maybe it’s best to leave out the S&P altogether and just go with all the other possible slices and dices.

That ain’t buy-and-hold. The idea of buy-and-hold was to stick with a plan long enough to see if it can really pay off. Switching to a different Permanent Portfolio every six months or so doesn’t do the trick.

Investors are kidding themselves. They like the buy-and-hold idea, and for good reason. It is indeed important to stick with a plan long enough to give it a fair test. But the promoters of the buy-and-hold concept did a poor job of pointing out the pressures that those following it will feel to abandon it. As a result, most would-be buy-and-hold investors are unprepared for those pressures and have no idea how to respond to them other than to change their understanding of what constitutes buy-and-hold regularly enough to keep up with their changing desires to own different classes of stocks.

Buy-and-hold is a good idea. But the popular formulation of it is unrealistic. We need a new understanding of how buy-and-hold can work, one that stands a better chance of playing out well in the world of flesh-and-blood investors.

The problem is that buy-and-hold became popular during the longest and strongest bull market in U.S. history. People came to think that you could buy the S&P and forget about it. That of course can never work. When the S&P is selling at reasonable prices, it is a wonderful asset choice. When it is selling at the sorts of prices that apply today, it represents a dubious long-term value proposition.

If we could just say that, we could develop all sorts of strategies for following what are basically buy-and-hold strategies but that are a good bit less rigid than what many of the promoters of the concept have endorsed. Until we develop that freedom, many investors will feel that their hands are tied. It is taboo to change one’s stock allocation or one’s mix of asset classes. But it’s becoming increasingly clear that it is foolhardy not to make some changes in one’s portfolio when the investing environment changes dramatically.

Is it okay to make shifts in the makeup of your portfolio from time to time? Of course. It’s not only okay, it’s pretty much mandatory. None of us knows it all starting out. We learn over time. If we didn’t put what we learned into effect by changing the makeup of our portfolios, there wouldn’t be much point to learning, would there?

We need to be more up front about the changes we make and the reasons why we make them. Many investors have given up on the S&P500 in recent years. For good reason. The S&P is dangerously overvalued. We should learn from our mistaken belief of yesteryear that the S&P would always be as attractive a buy as it was back in the time when it was available at a far more reasonable price.

Buy-and-hold should be a tendency, a goal, a principle. When we make it a dogma, we switch onto the wrong track. We all need to make changes in our portfolio composition and in our stock allocation from time to time. We should discuss those changes openly and thereby learn lessons from the mistakes we made at earlier times.

Today’s Passion: The article entitled Basics of the New Buy-and-Hold provides a groundwork for the development of a new way of implementing this strategy.

I Believe In Buy-and-Hold,
I’m Just Not a Fanatic About It

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We all know what’s good about stocks. Stocks provide great long-term returns.

Is there anything bad about stocks?

There is. The bad thing about stocks is the price volatility. You never know where you stand. One day your net worth is $100,000. If the money is in stocks, the number a year from today might be $130,000 or $70,000. You just don’t know. That’s scary.

The thing that determines whether you will become a successful long-term investor or not is how you deal with the fear caused by price volatility. The most common way of dealing with it is through denial. No one literally denies that prices are volatile. But many block this reality out of their minds. They would as soon draw up a will as develop a strategy to deal with price volatility. They act as if they believe that dealing with the problem will cause bad things to happen to them.

There have been three times in the past when stock prices have been where they are today. The average price drop for those three occasions was 67 percent. What are you going to do if the value of your portfolio is cut by two-thirds? Do you have a plan?

Lots of people say “buy-and-hold is my plan.” I don’t think that works. It’s too pat. Your life is going to change in dramatic way if the value of your portfolio is cut by two-thirds; lose that high a percentage of your accumulated wealth of a lifetime and there are going to be fewer options left open to you in all areas of life endeavor. You really are just not going to let that affect you? Are you sure?

Remember, if things go this time as they have gone all the other times, most other middle-class investors will be abandoning stocks when prices drop. It’s easy to practice buy-and-hold when everyone is saying it’s a good idea. It’s not easy when everyone is saying that the best thing is to abandon stocks. That will be what most people will want to hear when most people are abandoning stocks, and most stock “experts” have made it a longstanding practice to tailor their advice to meet the current desires of most of their listeners.

I don’t think you are going to hold if prices drop by 67 percent or by anything close to it. I don’t say that because I think you are weak. I say that because I don’t think any reasonable person would hold onto an asset that had lost 67 percent of its value. People don’t do things like that, and for a perfectly good reason. Doing things like that is nuts. Who the heck can afford to lose 67 percent of his or her life savings? Who the heck can afford to take that sort of hit and not take some kind of action?

Buy-and-hold does not work. It is not realistic.

At least that’s so of the version of buy-and-hold that has been widely promoted for 25 years now

I propose a new approach to buy-and-hold, one with all of the advantages of the now popular approach but without the terrible failing that it cannot work in the real world.

The problem with the conventional approach to buy-and-hold is that it ignores the way the stock market performs. Stocks are not really one asset class. They are two, two, two asset classes in one.

When stock prices reach extreme highs, stocks are a dangerous asset class. There are always huge wipeouts of middle-class wealth when stock prices reach extreme highs. There are no exceptions in the historical record.

When stock prices are normal or low, there’s not much risk. Stock prices might go down a bit from moderate or low prices. But probably not too much. And, if they do go down a good bit, the price drop is not likely to remain in place for long. At least that’s always been the case in the past. Again, there are no exceptions in the historical record.

Here’s my plan for escaping the worst effects of stock-market volatility: Lower your stock allocation when prices reach extreme levels (like those that apply today). That way you are heavily in stocks most of the time and get to enjoy the wonderful long-term returns generally associated with stocks. But you miss out on those huge price drops characteristic only of stock markets for which prices have been permitted to get out of control.

Make sense?

It makes sense to me.

What doesn’t make sense to me is the negative reaction I sometimes hear to this idea. It is my view that that negative reaction is a signal of defensiveness. It is because investors trying to pull off the conventional approach to buy-and-hold don’t really deep in their hearts believe that it can work that it makes them anxious to hear about other strategies, strategies that could help them if they could chill out a bit and think things through without too much emotion getting in the way.

Do I believe in buy-and-hold? Sure. Stocks rarely get to the sorts of price levels that apply today. So it is going to be a rare event when you are going to need to lower your stock allocation to protect yourself from monster price drops. It makes all the sense in the world to hold your stocks through the moderate ups and downs that apply for investors who buy their stocks at reasonable price levels. When the monster price crashs become a live possibility (probability? certainty?), however, I think it makes all the sense in the world to take a little something off the table until our fellow investors come to their senses and pull stocks back to more reasonable price levels.

It’s just an idea, you know? I think it’s a good one. If you don’t, that’s of course fine. We can of course still be friends. I ask that you not get mad at me because I put the idea forward and that you give the idea some thought if your initial impression is that it might make sense.

Today’s Passion: The Investor’s Scenario Surfer lets you test how you would respond to various return patterns without requiring you to put actual money at stake.

“The Focus on Active/Passive Is a Distraction”

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There’s good stuff going on at the Vanguard Diehards board lately. Petrocelli offers us a dose of The Common Sense That May Not Be Spoken when he says: “My conclusion after all these years is this: the focus on active/passive is a distraction. The focus should be on buying low-cost funds and diversifying. That’s all. The active/passive distinction can make for some fine pissing contests, but it doesn’t really accomplish a lot in the end.”

That’s good stuff.

I see Passive Investing as the Devil With a Blue Dress On of InvestoWorld. I say “don’t even start up a conversation, you’ll end up in the gutter with a bottle in your hand.” But Passive Investing didn’t get to be so popular just by being evil. There’s got to be some serious good in there or there wouldn’t be so many smart people who have fallen for it. Petro is pointing us to two of the obvious good points when he notes that those who push Passive argue for diversification and for keeping costs down. The other obvious good is that those who push Passive push sticking with a plan for the long term. Those three goods are a very big three goods.

That’s the blue dress part. I believe that God put me on earth to warn you about the devil part. So we better get to that.

Petro is proposing a non-dogmatic approach to Passive Investing. That makes sense. Apply the principles of Passive Investing in a non-dogmatic way and you can enjoy the three goods without falling into the pit. Where I might take issue with Petro a bit is re his possibly too glib suggestion that there are a good number of investors who can pull this off in the real world.

Delete the dogmatic from Passive Investing and you’ve got the one you’ll be proud to bring home to meet your parents. But what are the odds of getting Ms. Passive to go along? Is the Petro vision a fantasy?

I think the Petro vision can be realized. But I think we need to think it through a bit to make it happen.

You can avoid becoming dogmatic about Passive Investing by knowing its limitations. I think that’s the key. In order to make Passive Investing work out in the real world, you need to go in with a peaceful easy feeling, with both feet planted firmly on the ground.

Passive is dangerous in its suggestion that it is okay or acceptable or (heaven help us all!) even a good thing to stick with the same stock allocation when prices go through wild swings. Petro doesn’t care about that rule. He’s a practical guy. He wants what works. So I don’t think he would be opposed to the idea of people hearing why it’s critical that they lower their stock allocations when prices get to the sorts of levels that apply today. So Petro’s vision can work.

People need to be told about the realities, though. We’re born with evil hearts. We all feel temptations to buy into Get Rich Quick schemes. We all possess a desire to hurt ourselves, and unless we are warned about it in no uncertain terms, we will bite into the apple. We need all this stuff spelled out.

We need articles warning us of the dangers of failing to make adjustments in our stock allocations when price changes require it. We need calculators using the historical data to prove the point. All that good stuff. With all that good stuff, I think we can make some changes in the conventional approach to Passive to make it a workable investing strategy.

A generally Passive approach can work. A reformed Passive approach can work. A non-dogmatic Passive approach can work. A valuation-informed Passive approach can work.

A fellow named “Heaths” zeroes in on the good side of Passive a few posts later when he asks: “it seems that you agree that the degree of active is important and more than a distraction. Is that right?” Yes, that’s right. Investors should aim to limit the number of allocation changes they make. And beginning investors should limit the extent to which they engage in stock picking. Those Passive rules are good rules. it is the dogmatic jive talk of The True Believers that causes all the trouble.

Heaths focuses in on an extremely important point a bit later on. He says: “Most investors do not have the skill and/or temperament to actively invest, except perhaps in very modest ways. Because of this most should follow the basic tenets of passive investing: low cost, diversification, and stay-the-course. Some modest active investing might be desirable provided the investor fully understands all of the pros and cons of his investment decisions, but when in doubt most should err toward the passive.”

That’s stated reasonably. It’s not the crazy dogmatism that has made such a mess of so many of our boards over the past six years.

I don’t entirely agree with Heaths, however. I agree that there are important goods in the Passive model and that all investors should be taught about them. I don’t agree that we are not capable of knowing when we need to make changes in our stock allocations, however. All of us have experience paying attention to price when we buy cars and houses and bananas. I am highly skeptical of the claim that we are not capable of doing the same when buying stocks.

It’s true, though, that most of us do not possess this ability today. Heaths nails the current state of play.

You know why? It’s because nobody talks about these realities! When was the last time you heard Bogle give a speech telling us how to know when prices have reached a point where we need to lower our stock allocations? Or Bernstein? Or Burns? Or whoever?

When the Big Shots get down to the business of telling us what we need to know, we will listen. And we will learn. It’s not that we can’t do it right. It’s that the “experts” are so afraid of talking straight about this stuff that they never give us a chance to take the good stuff in.

I know whereof I speak. I have been talking about the effects of valuations on long-term returns on a daily basis for over six years now. Thousands of community members have either expressed gratitude or expressed a desire to learn more. These are ordinary people. These are Normals. These are “most investors.”

We are perfectly capable of learning. What we need today are some “experts” possessing the courage to get about the business of doing some honest and informed and non-dogmatic teaching.

Good job, Petro! Good job, Heaths! Let’s see more of the same!

Today’s Passion: The non-dogmatic Passive Investor is free to do all sorts of things that the dogmatic type dare not even think about. He can pick stocks! No, really. Read all about it in the article entitled Stock Picking for Indexers. Please don’t let any friends of Mel Lindauer know that I wrote that one. I’m in enough trouble as it is.

Stocks Are Not as Risky As You Think

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You often hear stocks described as a risky asset class. What people are getting at when they say that is that stock prices at some times go dramatically up and at other times go dramatically down. Most observations that stocks are risky are more properly viewed as observations that stock prices are volatile.

It’s not the same thing.

The risk that you are worried about as a middle-class investor seeking financial freedom early in life is that investing in stocks will cause you to lose money and thereby not make the progress on attaining your financial freedom goals that you were hoping to make. If you can invest in stocks in a way that provides a good deal of protection against the possibility that you will lose money, you have transformed the stock investment class from a risky one to a non-risky one.

You can do this.

Please take a quick look at The Return Predictor (click the button with that title on the left side of this page). The Predictor tells us that the most likely 10-year annualized real return for a stock purchase made today is 1.3 percent. That number suggests that there is a good deal of risk attached to buying stocks at today’s prices.

Stocks are not going to provide an even 1.3 percent return for 10 years in a row. There will be some years in which the return will be a good deal better than that. That obviously means that there will also be years in which the return will be a good deal worse than that. There could be some awful years in a 10-year patch of returns generating an overall return of only 1.3 percent (and it is possible that the 10-year return could drop as low as a negative 4.7 percent).

So stocks today are risky, no?

No.

Look at the Predictor’s number for the most likely 30-year return — 5.4 percent. That’s not bad at all. That’s more than double what you can get today from Treasury Inflation-Protected Securities (TIPS).

So stocks are not risky today then, right?

Not right.

Stocks are both risky and non-risky today. The level of risk depends on the mix of purposes to which you will be putting the money you are investing in stocks.

If the only possible purpose to which you will put the money is to finance your old-age retirement, and you are today decades away from retirement, it’s the 30-year number that matters. For you, stocks are not too risky today, despite their high valuations.

The flaw in most of the conventional investing advice is the assumption that most middle-class workers invest only to finance their old-age retirements. We all do indeed invest for that purpose. For most of us, though, the money in our portfolios serves multiple purposes. Perhaps we want to have money available to help our daughter get through college. Perhaps we want to have money available to start a business if our job turns sour. Perhaps we like the idea of having a healthy amount of savings because of the feeling of financial security it provides.

If those sorts of purposes apply for you, then looking just at the 30-year return number does not do the job for you. You should look at the 30-year number because you are investing partly to finance your retirement and the 30-year number tells you something important about how stocks can help you to attain your retirement financing goals. But you need to look at the 10-year number and the 20-year number too, if you are investing partly to advance non-retirement purposes.

For most of us, it is not too risky to direct a small percentage of our portfolio to stocks today because it would not cause us panic to see a large percentage loss in an investment class that comprises only a small percentage of our portfolio. For most of us, it is too risky to direct a large percentage of our portfolio to stocks today because it would cause us panic to see a large percentage loss in an investment class that comprises a large percentage of our portfolio.

Stocks are risky and non-risky at the same time. They are non-risky when held in small amounts, and the risk grows as you allocate more of your portfolio to stocks. It is your personal financial circumstances and life goals that determine how much of your portfolio you can direct to stocks before they become too risky.

You are in control. That’s why I say that stocks are less risky than you think. It’s not really a risk if you control it. Just lower your stock allocation to the point at which stocks are no longer risky for you and the risk attached to stock ownership for you has gone “poof!”

Stocks are a high-risk investment class for others. Stocks do not need to be a high-risk investment class for you. You are in control. Say “no” to high-risk stocks. Don’t buy stocks to the point at which you transform what should be a low-risk or moderate-risk asset class into a high-risk one.