A Rich Life

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

“Readers of the Studies Should Be Made Aware That They Are Not Reading Scientific Truths but Tentative Findings Depending on a Belief in One of the Two Models”

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Set forth below is the text of a comment that I posted in response to a question posed in the discussion thread for one of my Beyond Buy-and-Hold columns at the Out of Your Rut site:

I look forward to reading everyone’s thoughts on improvements that can be made to the methodology that goes in to these types of analyses

Re the methodology question, my take is that those who do studies of stock investing questions should always disclose what sort of methodology they are using. Buy-and-Hold studies are rooted in University of Chicago Economics Professor Eugene Fama’s Efficient Market Hypothesis and thus do not contain adjustments for the effect of valuations. Valuation-Informed Indexing studies are rooted in Yale Economics Professor Robert Shiller’s research showing that valuations affect long-term returns and thus always contain valuation adjustments. The two types of studies obviously always produce wildly different findings.

The important thing is that the readers of the studies be made aware that they are not reading scientific truths but tentative findings depending on a belief in one of the two models. The Old School safe withdrawal rate studies don’t reveal metaphysical truth re SWRs, they just tell us what those who believe in the Buy-and-Hold model believe the SWR to be. The New School SWR studies tell us what the SWR is for those who believe in the Shiller model.

All of the disputes that have raged for over nine years now are the result of the failure of researchers and investing experts to note that their studies are valid only if the premises on which the methodologies of those studies were built are valid. I believe in the Shiller model. So I obviously cannot say that I believe that the Old School studies are valid. It would be dishonest of me to do that. Each community member has to say what he or she sincerely believes to be the case. This should not be controversial!

Buy-and-Hold is rooted in a belief in the Efficient Market Hypothesis (Shiller had not yet published his research at the time Buy-and-Hold was developed). Buy-and-Hold is not Truth with a capital “T.” It is just an hypothesis that many smart people have over the years come to believe is true. All research done in this field should specify the model in which it is rooted. It is imperative that the investors making use of investing studies know that there is another model that produces research generating very, very different findings.

Rob

 

Beyond Buy-and-Hold #53 — This Is the Best Time in History to be a Stock Investor

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I’ve posted Entry #53 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s called This Is the Best Time in History to be a Stock Investor.

Juicy Excerpt:  Please use Shiller’s data to choose any month from 1870 forward and look at the P/E10 level that applied to determine what stock allocation you should have been going with at that time. Then move ahead 10 years to see what return applied. Shiller’s data doesn’t identify the precise return. But, if the P/E10 level stayed the same or rose or fell only a bit, the return was solid or at least acceptable. If the P/E10 level fell hard, the return was poor or perhaps downright panic-inducing. Please complete this exercise for as many cases as you need to to convince yourself that you should always look at the P/E10 level of stocks before buying them.

Valuation-Informed Indexing #54 — Data Combined With a Sound Theory Makes a Powerful Case

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I’ve posted Entry #54 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Data Combined With a Sound Theory Makes a Powerful Case.

Juicy Excerpt: As the poster using the screen-name “Fred Flintstone” notes: “The paper refutes a central tenet of the Boglehead investing philosophy.”

That it does.

But Greyfox brings up a point that has only rarely been examined in much depth.

He says: “Without some sound theoretical basis, there is really no way to know that some superior results of a strategy aren’t just random results that won’t repeat in the future.”

I strongly agree.

The fact that the entire historical record shows both that Buy-and-Hold can never work well for for the long-term investor and that Valuation-Informed Indexing will always offer higher risk-adjusted returns is powerful evidence in support of my favorite investing strategy. But Grayfox is right. Even 140 years of data is not enough. Without a theory that makes sense of that data, making changes in your stock allocation pursuant to the consistent message of the data is a dangerous business.

VII #43 — The Most Important Number in Stock Investing

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I’ve posted Entry #43 to my weekly Valuation-Informed Indexing column at the Value Walk site It’s called The Most Important Number in Stock Investing.

Juicy Excerpt: Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”

That maximum drawdown number is now my favorite numerical way of illustrating the secret to successful stock investing. Many experts define risk as volatility. But volatility is often not that big a deal. Moderate volatility, volatility not strong enough to cause you to sell your stocks, will not hurt you in the long run. But volatility that scares you enough to cause you to sell stocks when prices are down can set back your retirement dreams by many years.

So the best way to diminish the risk of stock investing is to invest in such a way that your maximum drawdown number is low. If your worst-case scenario is not that bad, you are never going to feel compelled to sell when prices are low and in the long run you will do fine. Being willing to abandon Buy-and-Hold for Valuation-Informed Indexing in one moment lowers your maximum drawdown from 61 percent to 24 percent. That is no small improvement!

Researcher Wade Pfau Endorses Idea of Permitting Honest Posting on Safe Withdrawal Rates, Stresses Bogle’s Contribution

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Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, yesterday posted to his blog words evidencing support for the idea of permitting honest posting on safe withdrawal rates. He made specific mention of the role played by Vanguard Founder John Bogle in helping the Retire Early and Indexing discussion-board communities become aware of the need to take valuations into consideration when identifying the safe withdrawal rate (it was by reading Bogle’s book Common Sense on Mutual Funds that I learned that the Old School safe withdrawal rate studies get the numbers wildly wrong).

Pfau’s article is called Can We Predict the Sustainable Withdrawal Rate for New Retirees? He states: “Retirees now frequently base their retirement decisions on the portfolio success rates found in research such as the Trinity study. Studies such as those are fine for what they accomplish: they show how successful different withdrawal rate strategies were in the historical data. But it must be clear that this is not the information that current and prospective retirees need for making their withdrawal rate decisions. John Bogle makes clear why in his 2009 book, Enough. Though he was speaking about stock returns, the same idea applies to sustainable withdrawal rates, since they are related to the returns of the underlying portfolio of stocks and bonds. He wrote, “My concern is that too many of us make the implicit assumption that stock market history repeats itself when we know, deep down, that the only valid prism through which to view the market’s future is the one that takes into account not history, but thesources of stock returns” (page 102, original emphasis).

The next paragraph of Pfau’s blog entry further explains that: “Future stock returns (and, therefore, future sustainable withdrawal rates) depend on the sources of returns: dividend income, growth of the underlying earnings, and changes in the valuation multiples placed on those earnings. The historical average success rate for a withdrawal strategy is not the information retirees need to know when determining their forward-looking sustainable withdrawal rate. As Mr. Bogle also writes, “But no, the contribution of dividend yields to returns depends, not on historic norms, but on the dividend yield that actually exists at the time of the projection of future returns. With the dividend yield at 2.3 percent in July 2008, of what use are historical statistics that reflect a dividend yield that averaged 5 percent – more than twice the present yield? (Answer: None.)” [the bolding in this passage appears in Pfau’s blog entry.]

I put a comment to the blog entry advancing the following words:

This is the most important paragraph ever written about retirement planning, Wade. You get it ALL in the paragraph quoted above:

1) You note the importance of the Old School SWR studies;

2) You make clear why we must make retirees and aspiring retirees aware that it would be dangerous to use one of the Old School studies to plan a retirement;

3) You focus in on Bogle’s important contribution (I learned that the Old School SWR studies are analytically invalid for purposes of identifying the safe withdrawal rate by reading Bogle’s book “Common Sense on Mutual Funds”); and

4) You explain WHY the Old School studies do not do the job for which tens of thousands of financial planners have employed them — because they do not look to the SOURCE of returns and there is no way to identify the safe withdrawal rate without doing so.

I will say a prayer that your new study will be the thing that will bring all the bickering we have seen in the Retire Early and Indexing discussion-board communities to a full and complete stop. We need healing and I believe that you have come up with the formulation that will finally help us achieve it.

Lots of people have made important contributions. That includes Bogle. That includes the authors of the Old School studies. That includes the thousands of our fellow community members who have expressed a desire that honest posting be permitted at every investing board and blog on the internet. That includes John Walter Russell. That includes you. I think it would be fair to say that that includes me.

You are a hero, Wade. I’m not joking about that. This is a delicate business. And it is a very, very important business. This investing study is an investing study that matters.

I look forward to talking these matters over with you soon at the Bogleheads Forum!

Rob

ITNR #51 — Is Buy-and-Hold Evil?

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I’ve posted Column Entry #51 at my weekly Investing: The New Rules column at the Death by 1,000 Papercuts site. It’s called Is Buy-and-Hold Evil?

Juicy Excerpt: The evil in Buy-and-Hold is that it makes those who follow it feel like fools.

There never was any support in the academic research for the Buy-and-Hold concept. There was a time when people thought that there was support. So for a time millions of smart and good people came to find great appeal in the concept. After the research came out showing that Buy-and-Hold is in fact the most dangerous investing strategy of all, they stuck to their belief because it would hurt their pride to acknowledge the mistake. That’s evil!

Buy-and-Hold by itself is no big deal. It was a good try. People who never make mistakes are people who never stick their necks out enough to learn anything. We learned a lot from our experience of trying out Buy-and-Hold and then discovering why it is such a loser idea. There’s going to come a day when people are going to look back at the Buy-and-Hold advocates as heroes for the advances we achieved because of their genuine insights (of which there have been many) and because of their mistakes (the discovery of which have led those of us who have left Buy-and-Hold behind to some very exciting places in recent years).

To say that Buy-and-Hold itself is evil is like saying that the idea that the sun revolves around the earth is evil. That idea was a mistake. It was something we had to go through to identify the next stepin learning how the world around us really works.

ITNR #49 — Game Changers: Part One

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I’ve posted Column Entry #49 to my weekly Investing: The New Rules column at the Death by 1,000 Papercuts site. It’s called Game Changers: Part One.

Juicy Excerpt: I use this column to spread the word about the exciting investing insights that follow from Yale Economics Professor Robert Shiller’s research showing that long-term stock returns are to a large extent predictable and that stock risk can thus be greatly diminished. My aim in this column and in the next is to put forward brief descriptions of 20 of the most important insights and thereby provide an overview of what this new model for understanding how stock investing works has to offer.

New Wade Pfau Study Shatters Market Timing Myths, Shows That Long-Term Timing ALWAYS Provides Higher Returns at Reduced Risk

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Wafe Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, has published new research showing that, contrary to the incessant marketing campaigns of The Stock-Selling Industry, market timing always works. That is, those who change their stock allocations in response to big price shifts with the aim of keeping their risk profiles roughly constant obtain far higher returns while taking on greatly reduced risks than do those following widely promoted Buy-and-Hold strategies.

Pfau states: “On a risk- adjusted basis, market-timing strategies provide comparable returns as a 100 percent stocks buy- and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.”

Pfau kindly credits my nine years of work in this field (during which I have argued forcefully that honest posting on safe withdrawal rates and other critically important investment-related topics should be permitted at every investing board and blog on the internet), saying “I am also extremely grateful to Rob Bennett for motivating this topic and contributing his experience and encouragement.”

In a show of his generosity of spirit, he also pays tribute to the leaders of the Bogleheads Forum, who have banned honest discussion of safe withdrawal rates and other important investment-related topics at their site, saying: “Because market-timing strategies are specifically not part of John Bogle’s investment philosophy, the author wishes to thank without implicating users including Adrian Nenu, afan, alec, Alex Frakt, bob90245, cjking, crl848, dmcmahon, DP, grayfox, Les, lostcowboy, market timer, matt, Mel Lindauer, Norbert Schlenker, peter71, pkcrafter, Rodc, SP-diceman, tadamsmar, wearethefall, and yobria.” That sort of comment heals wounds and heaven knows we need wound-healing in the Retire Early and Indexing discussion-board communities today.

The only part that I take issue with is the suggestion (Wade does soften the claim with use of the word “specifically”) that Vanguard Founder John Bogle does not see the merit in long-term market timing. Bogle talks out of both sides of his mouth on this question in nearly every speech he gives. However, the reality remains that Bogle has many times made the case for long-term market timing in clear and compelling terms. I learned about the need to engage in long-term market timing from Bogle’s book and Bogle has said in an interview that he believes Valuation-Informed Indexing can be a good strategy (he did not quite endorse it). It is true, of course, that Bogle often fails to distinguish between short-term market timing (which never works) and long-term market timing (which always works), presumably largely because of the marketing benefits that follow from encouraging investors in their Get Rich Quick fantasies (in fairness to Bogle, I believe that there is a good bit of cognitive dissonance at work here as well).

Pfau explained his purpose in conducting the study in posts he put to the Bogleheads Forum. Stock-selling experts have been telling us for decades that “timing doesn’t work.” And, indeed, many studies have been produced showing that short-term timing (changing your stock allocation because of some expectation of how prices will move in the next year or two) does not work. But how about long-term timing (changing your stock allocation in response to big price shifts with an understanding that doing so may not pay off for as long as 10 years)? Amazingly, Pfau was able to find only one serious study looking at this critically important question. Much of Pfau’s study is aimed at pointing out the flaws in the FIsher and Statman study, which evidenced doubts on the part of the authors about the merits of long-term timing.

It is of course a logical impossibility that long-term timing would not work, given Yale Economics Professor Robert Shiller’s research showing that valuations affect long-term returns. If valuations affect long-term returns, returns should be higher and risks should be reduced at times of low valuations. How could going with a higher stock allocation at times when returns are high and risks are low than one goes with at times when returns are low and risks are high not produce good long-term results? In a rational world, the question Pfau focuses on in his new study would have been analyzed in great depth by many researchers many years ago.

The only explanation for why it has not been is that InvestoWorld is today not generally a rational world. Modern Portfolio Theory (which posits that investors are paid higher returns for taking on more risk, the opposite of what logic says must often be the case if valuations affect long-term returns) has influenced our thinking to such an extent that we do not even know to research the most important questions facing us. As World-Renowned Portfolio Strategist Bob Dylan pointed out in his Idiot Wind Theory (a popular counter to the excessively rationalistic Modern Portfolio Theory), “we’re idiots, babe, it’s a wonder we can even feed ourselves.”

This does indeed appear to be the case. At least that’s what the 140 years of historical data available today for our inspection reveal to the researcher willing to listen to its Forbidden Message.

Pfau charts the nominal wealth accumulation of $1 invested at the start of 1871. The Buy-and-Hold strategy examined is a 100 percent S&P 500 portfolio. The baseline market timing strategy chooses either 100 percent stocks or 100 percent Treasury bills at the start of each year, depending on whether the value of P/E10 is below or above it’s historical average at that time.

The Buy-and-Hold portfolio was worth $95,404 at the end of 139 years. The Valuation-Informed Indexing portfolio was worth $124,147.

Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”

Noting that the Valuation-Informed Indexing portfolio is able to generate the same returns as the Buy-and-Hold portfolio while being out of stocks half of the time and thus putting itself at what should be a huge disadvantage according to Modern Portfolio Theory, Pfau also compares the Valuation-Informed Indexing portfolio, which has an average stock allocation of 50 percent, with a 50 percent Buy-and-Hold portfolio. In this case, the risks of the two portfolios are roughly equal but the returns for the Valuation-Informed Indexing portfolio are dramatically superior. The Buy-and-Hold portfolio has an end-point (2010)  value of $13,426. The Valuation-Informed Indexing portfolio has an end-point value of $94,866.

The study concludes: “Valuation-based market timing with PE10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

Truly amazing stuff!

We’re idiots, babe. But I think it would be fair to say that those who read this study and spend some time thinking through the implications that follow from it are perhaps a bit less idiots than they were on the day before they took that promising step into the light. Thank you, Wade Pfau!

Please find some room for reporting on this fellow’s work on your front page, New York Times editors! By the close of business today if at all possible!

“Everyone in This Field Should Be Urging the Authors of the Studies to Make Corrections”

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Set forth below is the text of a comment that I put to a blog entry at Wade Pfau’s site titled Trinity Study Updates:

we will not know if there is going to be an increased failure rate for another 20-30 years.

This statement is of course 100 percent true. However, I have a different and I think far more realistic and prudent and proper way of looking at things.

A safe withdrawal rate study is not supposed to tell us what withdrawal rate may work. It is supposed to tell us what withdrawal rate absolutely will work (presuming that stocks perform in the future as they always have in the past). A possibility that has only some small chance of coming to pass cannot properly be referred to as one that may “safely” be assumed. When aspiring retirees turn to research to learn the safe withdrawal rate, they are seeking to learn the withdrawal rate that will work in a worst-case scenario, not a best-case scenario or even a typical scenario.

In the past, valuations have always affected long-term returns. So the proper way to look at this question is to apply a valuation adjustment and see how well the 4 percent rule works then. The answer is — presuming that stocks perform in the future as they always have in the past, there is a 30 percent chance that a 4 percent withdrawal rate will work for retirements that began at the top of the bubble (January 2000).

Yes, there is a chance that the 4 percent rule will “work” for a third time. But those who are willing to speak frankly about these matters can say today that the odds are very much against it. The Old School safe withdrawal rate studies tell us not the safe withdrawal rate but the withdrawal rate that may or may not work depending on what sort of return sequence happens to pop up. Those are two very, very different concepts.

In the event that stocks perform in the future as they always have in the past, we are likely to see millions of failed retirements as a result of the analytical errors contained in the methodologies employed in the Old School studies. It is my strongly held view that everyone in this field should be doing all he or she can to urge the authors of the studies to make corrections and to warn the millions of retirees who have used these studies in their planning efforts of the dangers associated with using them.

William Bernstein, author of The Four Pillars of Stock Investing, once said that those considering making use of one of these studies to plan a real-world retirement would be well-advised to “FuhGedDaBouDit!” You gotta love a New Yawker’s way of getting to the heart of the matter in a whole big bunch fewer words than I put forward in this blog comment!

Rob

“I Need to Work Up the Courage to Work This Harder”

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Michael Kitces recently posted a blog entry at his site titled Why Does Everybody Think Safe Withdrawal Rates Are an Autopilot Program…. They’re NOT. Set forth below is the text of my second comment to the discussion thread:

Michael:

You are one of the good guys re this issue (and a good number of others). I am of course grateful for the link and for all the good you have done in this area.

The thing that troubles me is that you say that 4 percent “MAY be too high.” I presume that what you mean by that is that 4 percent may work. That is of course true. But is there any question whatsoever that 4 percent is NOT safe? At the top of the bubble, the data said that retirements using a 4 percent withdrawal had only a 30 percent chance of surviving 30 years. Is there any reasonable person alive who would say that a retirement with a one in three chance of working out is “safe”? Those retirements are high-risk retirements. The words “risky” and “safe” are antonyms, not synonyms.

There shouldn’t be any controversy over the calculation of numbers. Everyone is this field should acknowledge today that the Old School SWR studies misstate the realities by failing to take valuations into consideration. In any other field of human endeavor, the experts in the field would be doing everything they could to publicize how dangerous these studies are and to let people know about the correct numbers.

That doesn’t happen in this field because stock investing is so emotional an endeavor and lots of experts don’t want to hurt the feelings of their clients by letting them know that they have followed dangerous strategies. We need to change that. I would like to see more and more people coming forward asking at a minimum that NUMBERS be reported accurately. Is there any question in anyone’s mind today as to whether valuations affect long-term returns (and thus SWRs) or not?

Again, I applaud you for being one of the leaders in helping out re this matter. My concern is that the efforts that those of us who have been trying to steer things in a good direction have been taking have not been good enough for nine years now. The economic crisis is a serious thing. We need to do more. We need to be MORE frank with people. We need to start moving forward to the better places that are very much open to us once we all begin reporting what the data says ACCURATELY and FRANKLY and PLAINLY.

My words are not directed at you in particular, Michael. They are directed at everyone in the field. They are directed at ME. I need to work up the courage to work this harder too. We all need to be working together to get from where we are today to where we all deep in our hearts want to be tomorrow.

Rob