A Rich Life

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

Are Stock Gains and Losses Real?

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I’ve posted a Guest Blog Entry at the Consumerism Commentary site titled Are Stock Gains and Losses Real?

Juicy Excerpt: Losses suffered starting from super-high prices are never recovered. When you pay more than a fair price for stocks, a portion of your money is going to the purchase of stocks and a portion is going to the purchase of cotton-candy nothingness. Prices always return to fair value. So these price drops are not so much losses as they are the market coming to recognize phony gains experienced at an earlier time for what they really are.

Juicy Comment #1: In some cases I find this article confusing, in others cases I find it dangerous.

Juicy Comment #2: Gains are only real gains when you sell.

Juicy Comment #3: Once you get to retirement, the income statement rules!!

Juicy Comment #4: This entire article leans on the parenthetical definition of fair value “(that’s a P/E10 value of 15)”. Since it’s in a parenthetical I guess that means you don’t have to prove it?

Juicy Comment #5: “(That’s a P/E10 value of 15)” assumes:  (1) That stocks have a fair value; (2) That that fair value can be determined; (3) That the metric to determine it is P/E10; and (4) That the correct number for that metric is between 14 and 16.

Juicy Comment #6: The concept and strategy is so sound, that in my mind, it is irrefutable. Investors need to grasp the concept of how important valuation is in determining future returns. Everyone can make there own variations of how they implement the concept.

Playing Dominion vs. Playing the Market

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I’ve posted a Guest Blog Entry at the Free from Broke site titled Playing Dominion vs. Playing the Market.

Juicy Excerpt: It’s possible to finish a game of Dominion in 30 minutes.  Newcomers to the game make dumb mistakes the first time they play. They learn from those mistakes. They get better. Investing is a game that extends over 60 years of your life (if you start at age 25 and die at age 85).  By the time we figure the game out, it’s over.

Beyond Buy-and-Hold #8 — The How-To of Valuation-Informed Indexing

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I’ve posted Entry #8 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s called The How-To of Valuation-Informed Indexing.

Juicy Excerpt: It is the Reversion to the Means phenomenon that makes Valuation-Informed Indexing so effective. Most strategies relying on market timing involve so much guesswork that the odds of them coming through are not great. Because Valuation-Informed Indexing relies on an “Iron Law” of stock investing, it almost always produce better returns for those investors patient enough to wait for the phenomenon to kick in. Then it’s just a question of letting enough time to pass for the compounding returns phenomenon to transform a small edge gained by taking an almost certain bet into something substantial.

“I Am Intrigued By Your Ideas”

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Set forth below is the text of an e-mail that I received recently from Adam Butler. Adam is Director and Wealth Management & Portfolio Manager at Butler, Philbrick & Associates.

Hey Rob,

I am intrigued by your ideas, many of which overlap with the approach that we espouse at Butler|Philbrick & Associates. I would be delighted to hear your thoughts on our techniques and assertions, many of which are described in detail on our blog: http://gestaltu.blogspot.com.

Some thoughts on your approach, as i understand it. I eagerly await clarification where I have misunderstood:

Regarding the regression of long-term stock returns that you use in your models, I wonder about the statistical significance of the regression using all of the the available months. When I regress Shiller PE data back to 1870 against forward 10 year returns my findings suggest that the linear relationship is not strong enough to form the basis of a prescriptive model. This is due to the fact that intermediate valuations provide little guidance to long-term returns  However, when i isolate the top and bottom quartiles of valuations and regress against the forward returns from these valuation levels,  my regression strengthens considerably. Please see our blog post entitle Why Now Is Not The Time For Buy and Hold (http://gestaltu.blogspot.com/2010/03/why-now-is-not-time-for-buy-and-hold.html ), and Expensive Markets Revisited  for some of our (and others) thoughts on this.

I am extremely interested in how you have applied the findings from the Shiller PE regression analysis to find the safe withdrawal rate. Have you taken the expected return at a specific Shiller PE (based on your regression of all data) and combined it with the TIPS return, with specified allocations to each asset class, to arrive at an expected portfolio return, and then run a mean/variance analysis for various withdrawal rates to a 30-year horizon? What historical volatility numbers do you use? Do you include fees?

Have you read some of Moshe Milevsky’s work on safe withdrawal rates? If not, I encourage you to check out the following papers: (http://www.qwema.ca/pdf_research/2007APR_RUIN.pdf) and (http://www.qwema.ca/pdf_research/2007SEPT_SustSpending.pdf).

Our approach incorporates our findings on Shiller PE regression vs. long-term total real equity returns (1st and 4th quartile only) with Dr. Milevsky’s gamma distribution approach to sustainable withdrawal rates (See http://gestaltu.blogspot.com/2010/07/three-horsemen-of-retirement-apocalypse.html).

We have extended this approach by applying timing systems, such as Mebane Faber’s Multi-Asset Tactical Asset Allocation strategy (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1476225), and applied simple momentum overlays with extensive and robust back-testing, to offer strategies that substantially improve the safe withdrawal rates offered by buy and hold strategies from these lofty valuations. Note that we have adjusted the back-tested returns to our models by reducing them by the difference between long-termaverage stock returns (6.6% real total returns) and current regression prescribed long-term returns. This aligns our back-tests with the implications of lofty market valuations (See http://gestaltu.blogspot.com/2010/04/and-now-good-news.html).

My partner, Mike and I would be very interested in touching base over the telephone to discuss our mutual findings in an effort to swap best practices. You will find our contact info, and a little bit about us on our web site: http://www.butlerphilbrick.com.

I look forward to hearing from you soon.

Adam

“It Was An Epiphany….VII Beats Buy-&-Hold Over Most Long Holding Periods at Much Lower Volatility”

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Set forth below is the text of an e-mail that I recently received from a site visitor named Sam. Sam had sent me an earlier e-mail and this e-mail of his was in response to my reply to him.

Hi Rob,

Thanks for your e-mail. I had not seen those ValueWalk articles you wrote yet, and I just read parts One and Two of the Investment Strategy Tester this morning. I’ll bet some people would be surprised about the conclusions that the risk of low stock allocation can exceed that of high stock allocation. I wasn’t particularly surprised because I had perused your PassionSaving site and had embraced your heretical (yet common sense) valuation-informed indexing (VII) philosophy. I need to track down the other articles you published, and peruse them.

When I came across your PassionSaving site a couple of years ago, it was an epiphany. Since I had been losing a lot of money during the most recent market crash, I was highly motivated to search for a better strategy than buy-and-hold (BAH) to navigate through the crisis and to use going forward. Although your arguments were logical, and I realized immediately that VII would certainly beat BAH on a risk-adjusted basis, I was skeptical that it could consistently beat BAH on an absolute basis.

Since I am a math geek/engineer willing and able to create back-test simulations, I created a big interactive spreadsheet that used a user-specified, parameter-based stock allocation versus P/E10 curve (I used a Backwards-S-shaped, hyberbolic tangent function) to model the resulting hypothetical portfolio value based on the historical stock market price and prevailing interest rate data. The output curves plotted the portfolio-value versus time curves of  buy-and-hold versus the user-specified stock allocation function. I am working on making a slider tool that the user could use interactively to change the shape of the stock allocation versus P/E10 function instead of plugging in the equation parameters.  I would be happy to send you a copy, but it uses macro’s so you’ll get a warning about that. For that reason, I am not certain it is suitable to post at a website. I have attached a couple of screenshot images of a typical stock allocation curve. What you can see is how the VII strategy beats the buy-and-hold over most long holding periods, at much lower volatility.

There are a couple of caveats. Before 1990, trading fees were very high, and no ETF’s existed to easily obtain market performance and diversification. The other caveat is that it is impossible to earn the best interest rate on cash when it needs to be ready to deploy into stocks at the drop of a hat. For example, right now money markets are yielding nil.

The upshot of this is that I am ahead of where I was in June 2007, before the crash, and I am “never ever ever no never!” going to be over 70% in stocks unless the P/E10 drops below 13 again.

ValueWalk.com Article #8 — The Investment Strategy Tester

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The www.ValueWalk.com site has posted my article entitled The Investment Strategy Tester: Part Two — Changing Your Stock Allocation in Response to Valuation Shifts Beats Sticking With a High Stock Allocation.

Juicy Excerpt: Now it’s the 100-percent-stock portfolio that lacks a tradeoff. Look at the 10-year and 15-year and 20-year numbers. The 100-percent-stocks portfolio has worse worst-case scenario results. But it does not have better best-case scenario numbers. When stock prices are out of control, high stock allocations offer added risk with no potential for added return. Not too appealing a deal!

“The Smart Investor Must Be Willing to Make Much Less in Boom Cycles”

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Arty put up two especially important comments to a blog entry from last week. I am using his two comments as today’s blog entry to be sure that all visitors to the blog see his words and are able to profit from his insights.

The comments were put to the blog entry entitled Passive Investing Is For Extemists: The Critique.

Here are Arty’s words:

Rob,

These are all important comments. John’s comments suggest to me the aim of avoiding big losses in down years.

I infer from Rob’s comment (whether he intends so or not) what I see as most important consideration to successful (long-term) investing: commitment to a “strategy.”

The opposite of commitment is selling-out, (usually low and usually at the time of low market valuations but high *perceived* risk, like last November). The issue for me, is that a good strategy has to be one in which you have conviction. The biggest threat to conviction, in my observation, is sustaining big losses. And I think most investors are indeed risk-averse, regardless of the silly little test they take in initial consults with an advisor when designing a portfolio strategy.

So, a successful strategy—whatever it is—has to be one that reduces the far left fat tail—dampens the big loss. Absent that, most investors are going to be tested—likely to their limit. Recognizing this changes the relative experience of *living with* a particular strategy even as two strategies may produce similar returns.

After playing with your calculator, I did some detailed observations using specific asset classes (funds that many individuals could have invested in). Here’s a specific example (using specific stocks and bonds) that embraces several valuation periods:

Portfolio 1 (1972-2008)
Cost adjusted Gross Return: 9.39%

Best year (among other similar): 1975 38.7%

Biggest losing years:
2008: -37.04%
2002 -20.96%
2001: -10.97%

Portfolio 2 (1972-2008)
Cost adjusted Gross Return: 9.6%

Best Year (by far): 1985 22.8%

Biggest losing years:
2008: -7.59%
1973: -1.19%
1974 -0.67%
(small gains in 2001 and 2002)

Similar returns between the two strategies over the same long time period. Now, which strategy would you rather have lived through? Which strategy would an investor have been likely to adhere to?

Keep in mind John’s point:

“Waiting 30 years will work well enough if you can stand what happens in the meantime.”

Arty

Rob, 

Yes. I think our discussion locates the crux of the matter, and it is indeed found at the emotional. But is has taken me some added work to understand the real threats, vice the lesser order issues that tend to dominate most discussions.

A successful, long-term investor must have a belief system and be committed to a strategy that avoids the great risk of “bailing-out” (which includes either performance chasing or outright going to cash).

Now, here is where it gets interesting, because there are very different ways to accomplish this, but to me, they usually share the common feature of Fat Tail reduction (an often used Larry Swedroe term, actually). And it might be accomplished with a valuations-based strategy, as you have endeavored to discover, which, not surprisingly, requires low beta exposure—but at high valuation periods and not necessarily throughout.

The two examples I provided, above, were buy and hold portfolios across a 37-year period using funds that many investors could access.

The first portfolio was obviously a TSM fund—100% stocks! Clearly, if you held that portfolio your returns were nice, but you were tested—and I wonder how many could have held it 37 years.

The second portfolio, while returning about the same, did not compete in bulls, but hardly suffered much in bears, even last year, and not at all in ‘01-’02. It was a strategy whereby the equities were “Tilted” to small value and emerging markets (risky asset classes) but dampened by 70% Short-term Treasuries, thus accomplishing a low beta exposure and fat tail reduction. It is unlikely this investor was severly tested in any downturn. That is good.
Low beta being the key to reducing the big losses, and, in my view, staying committed for that long.

The portfolio below (#3) also reduces fat tail risk, uses TSM as its sole stock allocation and adds 2 low-correlating asset classes to it (Gold and LT Treasuries), and has a similar return to the other two portfolios, while being *very* different:

Portfolio 3 (1972-2008)
Cost adjusted Gross Return: 9.79%

Best Year (by far, the rest much lower): 1979 42.1%

Biggest losing years:
1981: -3.9%
1994 -2.5%
(small gain in 2008!)

This is the Permanent Portfolio and someone using a buy and hold strategy with it would have earned those returns across 37 years.

I’m not recommending any of these portfolios/strategies just making an observation on why they work.

So buy and hold can work over the a long term, and stay protected in the short term, and return well over time. But there is a catch.

The portfolios that I presented (#2 and #3) carry a risk—not surprisingly, an emotional one—that is their greatest threat; it is called “tracking error regret”. That means, they may perform very differently than “the market”. That means in bull markets, these portfolios will still make some money but be outperformed, badly, by traditional portfolios. (But, recall, these are the same traditional portfolios that then get crushed in the bears!)

But, the smart investor who respects the greatest threat of all, “bailing-out” in a big downturn, *must* be willing to trade-off not doing well as his friends in bull markets. He must be willing to make much less in boom cycles to lose far less in bust cycles. That is how one can actually “stay the course” with a single allocation. But the tradeoffs must be fully understood.

A valuations-based strategy also carries this risk. For if you were worried in 1993 at P/E 20, you may have reduced too much and missed 7 great years, making far less than your friends. Here too, tracking error regret is the emotional threat that must be understood to profit.

As evidenced by famous “Plan B” options, even veteran investors don’t know this, probably because they were advised, outright or subtly, to hold more beta exposure than they should (for all sorts of reasons like fear of inflation or blatant optimism or whatever). And they did not envision just how tough the tests were or how easy it would be to quit. But it takes education on the matters that truly *matter most*, and then belief in one’s implementation of that education.

Arty

About Our Unique Investment Strategy Calculator

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I’ve added an article entitled About Our Unique Investment Strategy Calculator to the “Strategy Tester” section of the site. It sets forth 10 basics questions and answers about the new Investment Strategy Tester calculator.

Juicy Excerpt: The Strategy Tester runs 1,000 tests of any of the scenarios examined by The Scenario Surfer and reports the probabilities of various outcomes. For example, you might want to know whether there are any 30-year return sequences starting from the top of the bubble that might come up in which rebalancing to an 80 percent stock allocation would provide better results than a simple Valuation-Informed Indexing strategy. The calculator reports that there are very few. At 30 years out, the worst-case scenario for the VII strategy is better than nearly 50 percent of the possible scenarios for the rebalancing strategy. The most likely scenario for the VII strategy shows a portfolio balance about 50 percent larger than the portfolio balance for the most likely scenario that applies for the rebalancing strategy. Hundreds of different strategies can be compared through use of the new calculator.

“I Was Hooked on [Passive] Indexing, But Something Inside Made Me Wonder…”

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I recently received an e-mail from Coleen saying:

“I have recently begun researching/learning about investing.  I was hooked on the idea of index investing, but something inside me made me wonder…”too good to be true?” and  “What’s the downside?”.  I happened onto your site and “Value-Informed Indexing” seems to make sense.  Here’s my question..I was looking into 3 index funds from Vanguard (an international, a total stock market and a bond index fund) and I’m wondering if “Value-Informed Indexing” could be applied within these 3?  Basically investing heavily in the international and total stock market funds now and when they go up to  transfer a percentage over to the bond fund?  Am I understanding or would I need to be in something other than the bond index funds?  Also, I was wondering how you are doing today and if you have posted since the market turned in the past few months?”

Set forth below is the text of my response:

Colleen:

Thanks for visiting the site and thanks for writing.

For my thoughts on the market crash, please click on the “A Rich Life” button at the left side of each page of the site. That’s where my blog is located. I’ve been posting every business day. My focus in recent months has been on recording podcasts. So you could also click on the “Robcasts” section and just listen to whatever titles seem of interest. I’ve commented extensively on the price crash in the first 50 podcasts.

I believe that what you are asking is — what should I be invested in as the alternative to stocks at times when stock prices are too high? The conventional recommendation is to go with bonds as the alternative to stocks. My preference is for Treasury Inflation-Protected Securities (TIPS) purchased at times when they are providing a solid long-term return. But I see this as being a judgment call. A case can be made for bonds in some circumstances. To work through the points pro and con TIPS or bonds would take an entire article (I’ll put that on my list for the future).

The analysis is — which option best counters stocks? I like TIPS better because what I am trying to counter is the unpredictability of stocks (TIPS are the most predictable asset class I can think of). However, I haven’t worked this particular question hard enough to have a strong opinion. I tentatively prefer TIPS as my stock counter. But I can see circumstances in which bonds might make sense. It might also be possible to use both as counters.

You’ve asked an interesting question that we have not explored in much depth. You might want to direct your question to John Walter Russell as well. John is my partner in development of the calculators. His site is www.Early-Retirement-Planning-Insights.com. He has a Letters to the Editor section. I know he would be glad to take on your question and I would like to hear what he says about it. My guess is that he might have a better informed take on this particular question tham I am able to offer. You’d be helping other community members by asking him about it as I am sure that there are others who are also wondering about this.

Welcome to the Financial Freedom Community!

Rob

Note: I subsequently recorded Podcast #79, What Should You Be Investing In When You Aren’t Investing in Stocks?